The rally in peripheral euro zone debt seems unstoppable. Thank – or blame – the European Central Bank. Its talk about easing monetary policy, maybe as soon as June, is pushing bond yields to record lows in countries that faced borrowing costs of up to 17 percent a few years ago.
Italian, Spanish, and Irish 10-year bond yields were at all-time lows and below 3 percent on May 9. Portuguese ones fell to 3.45 percent, their lowest since early 2006. The ECB is the primary driver of the rally. After all, investors’ hunt for yield in the euro zone can be traced back to Mario Draghi’s 2012 pledge to do “whatever it takes” to save the single currency.
But lower borrowing costs in the euro zone periphery are also a reward for the bitter medicine these countries took during the crisis. A harsh form of market discipline forced governments to both implement fiscal austerity and pass unpopular reforms. This helped transform a vicious spiral of credit rating downgrades into a virtuous circle of upgrades, which lures in more investors.
There is a fly in the ointment. The market discipline which forced governments to take difficult steps has receded just as reform fatigue is gaining. Record-low borrowing costs will make it hard for politicians to convince voters that more tough measures are necessary – although low or negative inflation has the effect of keeping real interest rates too high for comfort.
So far, investors are too preoccupied with the quest for yield to bother about this. But they may take fright at some point if they feel that euro zone governments are losing the willpower to get themselves into better shape in time for the next economic downturn.