Beware the restive euro bond raiders

FT.com

Will the bond market vigilantes come to the eurozone and wreak havoc? The strong market reaction to a change in expectations about the monetary policy of the US Federal Reserve suggests that the period of ultra-low market interest rates may be coming to an end sooner or later. The markets recovered at the end of the week hoping that this moment might arrive later. For the eurozone, the implications would neither be immediate, nor direct - but potentially significant.

To see the impact, it is important to understand why bond market conditions have become so propitious since last summer. One reason is that investors firmly believed a pledge from Mario Draghi, president of the European Central Bank, to provide an unlimited backstop to the eurozone’s sovereign debt market. It also attached strong credibility to the notion of a eurozone banking union. This, however, remains work in progress.

If both of those projects were for real, the eurozone crisis would indeed be over since the combination of the two would end all default risk. The ECB would guarantee the solvency of the states. The banking union would guarantee the solvency of the banks. The ECB would guarantee the liquidity of the banks. And the banks would guarantee the liquidity of the states.

That last point is particularly important, as banks have become the main buyers of their home nation’s sovereign debt. A rise in global market interest rates may well have a negative impact on the eurozone economy, but it could not break the eurozone apart. There are still all sorts of other risks - macroeconomic and political. But at least the eurozone would not face the risk of a lethal bond market crisis.

Back on earth, the premise may not hold up under the kind of stress we may be about to see. Last week’s hearings in Germany’s constitutional court brought a reminder of how thin the substance is behind the Outright Monetary Transactions - the yet untapped program for buying government bonds that stands behind Draghi’s guarantee.

When the ECB talks in English, the program is uncapped. But once it uses German, the emphasis is on the limits of the programme, rather than its potential. This is not so much a translation error but an extremely risky communication policy to send diverging messages to English-speaking investors and German-speaking eurosceptics. Jörg Asmussen, a member of the ECB’s executive board, told the court last week the program was unlimited only in the sense that there is no formal ceiling imposed in advance, but was capped in reality because of its design. Draghi’s message to international investors was much less nuanced. I am still struggling to come up with a snappy German translation for “whatever it takes”.

The problem is not the German constitutional court as such. It has no jurisdiction here. It is that German legal interpretation has a habit of prevailing in eurozone crisis responses. The ECB is not going to monetise debt on a large scale. And this is something bond investors may ultimately realise as they re-evaluate their risks. It is best to think of the OMT as a stabilisation program that can be triggered in a market panic. There may be no formal financial ceiling but this programme is not designed to address the solvency problems of various private and public entities in the eurozone.

What will also become clearer in due course is that the banking union may not fulfil its promises either. Its principal economic function would have been to separate banking and sovereign risks. The main debate now is whether the European Commission or someone else should run the resolution authority that would clear up the wreckage of failed institutions.

The real issue, however, is how to insure against potentially enormous systemic risks. An optimistic estimate of accumulated losses from asset price bubbles, market crises and a double-dip recession with no clear path of recovery would be 5 per cent of the eurozone’s aggregate financial sector balance sheet. That would put the total of hidden losses by banks at about €1trillion, a large portion of which would have to be covered through new capital. You could double or treble that without appearing unreasonable. Add in a certain amount of sovereign debt unlikely to be repaid, and you have a decade of unprecedented zombification, unprecedented default, or both in succession.

Bond market sentiment is, of course, hard to forecast. But it only takes minuscule changes in perceived default probabilities to produce big shifts in market interest rates. This is why we have observed long stretches of self-fulfilling sovereign debt rallies and downturns. Rising rates give rise to a vicious circle because investors question the borrower’s debt sustainability and want to be compensated for the higher risk. Likewise, when rates fall, a virtuous circle sets in.

In addition to a shift in expectation about US interest rates, there is quite a bit of bad news still to come out of the eurozone itself. It is hard to overestimate the negative impact of the rise in value added tax the Italian government is considering to finance a cut in property taxes. Greece, Cyprus and Portugal all remain on an unsustainable path. So does Spain.

What we can predict with a high degree of probability, however, is that once sovereign yields rise again, the eurozone will not be prepared.

Copyright The Financial Times 2013.