Were the markets bamboozled by the Euro? November 15, 2011 at 6:28 am

This picture is from Pictet (via the ever helpful FT alphaville):

Eurozone bond spreads before and after union

Alphaville’s question is, given this, was Union sensible? I think it clearly was; on a weighted average spread basis, the EZ countries are still doing better than they were prior to the Euro, and even if they weren’t, those eight or nine years of low spreads were worth having (or at least they would have been if the money had been spent sensibly). In any event, what interests me more is why spreads were so low for so long. It seems to me that there are three (not necessarily mutually exclusive) possibilities:

  • Despite having thousands of smart people looking at these things, the markets were wrong about what the bond spreads of Eurozone countries should be. They have now woken up.
  • The markets have over-reacted to current events, and spreads are now well above where ‘fundamentals’ would suggest they ‘should be’ (whatever that means).
  • The markets are right, and the spread changes have been in response to new information, specifically the discovery that leading EZ politicans are unwilling or unable to backstop the periphery.

I’m not sure where I come out on this yet…

2 Responses to “Were the markets bamboozled by the Euro?”

  1. Or, the markets correctly guessed that all the debt would be guaranteed by the core nations so didnt do any credit risk analysis unti 2009. At that point the market started to reappraise the connections between the core and periphery and started to become net sellers. Similarly European banks became net sellers because of the new basel 3 rules that make sovereign bond price movements pass through the capital ratios. At the same time a number of large hedge funds started betting with leverage on the chance of breakup making i) and ii) much worse. They have so far rightly guessed that there is not enough coordination, cohesion and imagination from the european authorities to really head off concerns. As a result the french german spreads creep up. Markets have actually been quite efficient, its just the consequences that are disastrous. To see that you have to look at the current accounts of all the different eurozone nations. Uncompetitiveness has been reinforced to the point that it is hard to recover.

  2. EU govies are treated favourably for Basel/solvency regimes, they do not need any risk capital allocated, so the market was not driven (entirely) by credit risk, but by reg arb.

    Markets never believed the “no-bailout” – and right they were. (and now recognise that Germany cannot bail out everybody, the “real” credit risk is priced in again).

    Pre- EZ admittance, all prospective members executed borrowing restraint and limited spending sprees to meet the criteria – thus the low spreads were justified to an extent in the beginning.

    However, the periphery – once safely over the hurdle with no exit clause – went on a spending spree – which was disguised by worldwide liquidity…..

    A bunch of misleading incentives, I would say.

    And now many (including Germnay) are more or less insovolent, or at least used to spending levels that are unsustainable –

    the wake up call will be unpleasant, very unpleasant.