A narrow path
The two engines of the euro zone bond rally are sputtering. Rising yields on risk-free debt are hitting one, and the German constitutional court hearing has thrown a little sand in the other. But a tougher ride for peripheral debt is not necessarily all bad.
Both engines had been running smoothly for months. Zero or near-zero returns on low-risk paper encouraged investors to search for higher yields elsewhere, including euro zone periphery governments. And European Central Bank Chief Mario Draghi’s commitment to buy government bonds, if necessary, made those weaker governments look less risky. The plane went fast. Yields on Italian 10-year bonds fell from near 6 percent in 2012 to a pre-crisis below 4 percent.
The rally was a relief from the chaos of 2011, but it made governments complacent. Pressure for reforms, for example the banking union, waned.
But now yields on low-risk debt are rising, as the U.S. Federal Reserve contemplates less ultra-loose monetary policy. Every 100 basis point rise in U.S 10-year Treasuries will push up German yields by 81 basis points, RBS estimates. If safe debt yields more, peripheral securities are less attractive.
And Draghi’s potential bond buying looks less secure after a grilling in the German constitutional court in Karlsruhe highlighted issues the market had chosen to forget. It became clear that OMT is not unlimited, as Draghi had promised. The central bank will only buy government bonds with maturities between one and three years – a maximum of 524 billion euros. Also, the Karlsruhe muddied Draghi’s original commitment that the ECB would be exposed to credit risk like any ordinary bondholder. In Karlsruhe, ECB’s director Joerg Asmussen admitted that central bank losses on debt restructuring would amount to banned monetary financing.
If effect, in a crisis the ECB would have a dreadful choice: infuriate Germany by stretching its mandate or anger investors by resisting taking losses. Bond buying sounds more like a crash landing than a parachute.
Draghi won’t want the market to panic – that could bring back the chaos that he so effectively ended. But he must be hoping that the slower and bumpier flight shakes government out of their complacency.