Why The Bond Bubble In Peripheral Europe Is A Problem

Tyler Durden's picture

Authored by Raoul Ruparel, originally posted at Forbes,

Headlines were made earlier today as Ireland’s ten year borrowing costs dropped below the UK’s for the first time in six years. Given that it only recently exited a bailout programme and not long ago was mired in the worst crisis in a generation, this is a pretty astonishing turnaround.

Nor is Ireland alone. Spain and Italy can now borrow at similar rates to the USA on ten year debt. More broadly, in the past year peripheral countries borrowing costs have plummeted to levels seen before the crisis, or below, as countries begin exiting bailouts and returning to the markets.

What is driving this and is it a bubble?

There are three key factors at work here:

ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.


There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.


Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.

This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation) – the WSJ Heard on the Street touched upon the issue here. As the graph below highlights, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.

Could this present a problem? (Hint: Yes)

While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.

The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.


More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.


The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.


As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.


The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.

Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

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williambanzai7's picture

All funded by the same printing press.

NotApplicable's picture

So... who is Corzine gonna bankrupt to "fix" Europe this time?

NoDebt's picture

"Demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries."

Stop!  Hault!  That's it, I'm punching out.  Everytime I hear somebody point to "economic fundamentals" as a reason for justifying it being over-valued, I immediately stop reading.  

strannick's picture

The bond rates are the same across the Banana Republic board because as Chris Powell says "there are no markets, only govt interventions"

BandGap's picture

Maybe this will bring Johnny back! That lovable old lunk.

NOTaREALmerican's picture

When nothing can fail why would the bonds prices be different from each other?

CrashisOptimistic's picture


The elimination of moral hazard says all central banks have no further inhibitions.

THERE CAN BE NO DEFAULTS.  US T's will never default.  The Fed will stop that.  Yes, this can destroy the dollar but that is not relevant to whether or not US T's or other sovereigns can default.  They Can't.

Add to that not the absence of inflation mentioned above, but the reality of no economic growth and you have what we see.

It's not a bubble.  The bond guys usually get it right.  There is no economic activity, no prospects of it in the future (as oil scarcity drags it all down), and no chance of default.

gatorengineer's picture

While I generally agree, keeping it all orderly and in lockstep has been the challenge.  What I dont understand is how is Greece all of a sudden magically paying its bills, without further european aid.  Where are the IMF and EU inspectors demanding the austerity.....?

Lastly the assumption or presumption that the Germans will go as quietly into the night as the US and the Japanese remains to be seen.  After then Nigel and his crew in the UK, could make some noise unless they get Droned.

delivered's picture

Agreed and agreed with both previous comments. Also note that with so much capital being deployed in the public debt markets, has to be a drain on private capital formation (which will continue to be a drag on these economies). Basically its telling me that there's nothing left to invest in so stick it in the credit markets with countries that have such high debt levels, they will never be repaid. BTW, with Portugal and Greece returning to the credit markets, this is more of a function of money looking for a home than countries that have turned the corner with strong fundamentals. And the deflation issue should really be a concern as if this takes hold, the entire economic base will start to shrink more quickly which ultimately will result in reduced tax receipts (from lower corporate/personal earnings) and higher deficits leading right back to the same place all of these countries started. 

These lending rates really tell the story of just how distorted the markets have become. There is no way countries as indebted as Italy, Spain, Greece, etc. should even be able to borrow, let alone at these rates. But the magic of CB printing continues on its merry path until one day, it doesn't. Just no way out now as the junkies are being fed by the pushers. Worse thing is, these countries are being given false signals of security/success that their policies are working and they can continue to run deficits, borrow, and spend excessively without a second thought. Hell when money's basically free, why not as just look how successful Wall Street has been in the US!

SmallerGovNow2's picture

so why not just print money and give to everyone and then no one has to work for a living?  oh wait....

debtor of last resort's picture

If they don't spend more or borrow more, the whole eurozone falls apart, and with that Deutsche bank, and with that....

Dr. Engali's picture

When I read this article  "originally posted at Forbes" I was skeptical, but I was willing to give it the benefit of the doubt. as soon as i read "possibly the most important factor is the very low inflation in the eurozone" I knew I was right to be skeptical. The only reason the spreads are so thin is because everybody is front running the central banks.... Period. Take out the Dragqueen put and watch just how fast those spreads blow out.

CrashisOptimistic's picture

Well of course Doc, but the central banks are there.  You can't take them out.

They guarantee no default risk.  The rest is relentless decline of economic activity and . . . it's not a bubble.  They are accurately priced.

gatorengineer's picture

yes but the Draghi has to go to Merkel for more money soon, or it may be a long hot summer......  been a while since a few Paris suburbs have burned....

elwind45's picture

Everybody should know several things going for EUROPE. First the American tax payer subsides our brother on the continent and our cousins the Swiss help us and them out with European currency unity? But what is exciting is SUMMERTIME IN PARIS and LONDON OR CAPRI and then maybe a EURO QE WITH ITS WARCHEST? hell no! Let us decide to suck the yanks dry firstly SINCE we own them anywho? Tah tah its good to rule even if the subjects resemble naked sheep persons

bobby02's picture

Is this fluff what passes for analysis these days? A bubble in critical thinking skills?


Last I checked, Spain and Italy borrow in euros. Has the US Treasury abandoned the dollar? If not, your comparison is totally bogus. Moreover it's not the level of yields, but the spread to the risk-free rate, which in this case is Bunds, not Treasuries.


Don't get me wrong, I understand advertisers pay the bills on Internet sites, but infomercials should be marked as such.

Oracle 911's picture

Everybody thinks, the ECB will be the biggest fool, like the FED. What happens if not?

Well it will be ugly, and probably the EU and Eurozone will implode.

Freebird's picture

Er, currency swaps...

elwind45's picture

Last we brooched this subject I thought we all agreed it was BILL GROSS burying his dog and yet this something amiss in Euroland meme continues to yawn us all sleepy town? Wake me when ZIRP fucking changes PAL!

elwind45's picture

QE is for America ZIRP not so much?

elwind45's picture

Lets say you and Janet are dating and you give her all your money to help her brother but instead she gives it to her other boyfriend? ARE YOU FEELING IT NOW?

newworldorder's picture

A very apt description of reality. Only most do not get it.

Fuh Querada's picture

It's all OPM (other people's money). What pension fund manager gives two dry fucks if the portfolio for your retirement is stuffed with this junk. By the time you retire he will have vanished. To round off the scam, the rating agencies get paid handsomely to back up the Ponzi.

strangeglove's picture

thank you BenYellin!


newworldorder's picture

Endless faith is being exhibited that the US FED will backstop any and all financial issues coming from the TBTF banks in each Euro country. The Draghi promises are just a convenient smoke screen for the uninformed masses.