Beware Euro Area: Bond Markets Are Fickle

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The EU’s system for keeping euro state budgets on track is as important as ever, especially when interest rates are low.

Bond markets are notoriously fickle. They often seem to be driven by sentiment rather than deep analysis. The experience of 2006-08 shows they are not infallible. They are not a good guide to long-term economic prospects. Rating agencies seem to follow sentiment rather than lead it. They are like a bus driver who is looking out the back window rather than at the road in front.

This is the context in which France and Italy should be assessing the wisdom of submitting draft budgets this month to the European Commission, in accordance with the Stability and Growth Pact, which go back on commitments they had previously given to reduce their budget deficits to below 3% of gross domestic product (GDP).

The low rate of interest at which most European governments can borrow at present can be explained by two factors, which are not necessarily permanent.

1) Sovereign bonds — that is bonds issued to allow governments to borrow — are treated as entirely risk-free assets in the balance sheets of banks, under the rules the European Union (EU) has set for calculating the solvency and adequacy of capital of banks. This is a somewhat artificial assumption, in that it implies there is a zero risk a European government will ever default on its bonds — in other words, fail to pay all the interest due and repay the bond in full and on time. The scale of debt relative to income of some European countries might lead some to question this assumption, unless, of course, there is a big surge in either inflation or economic growth.

2) Prevailing interest rates are now so low, the amount of money seeking a home is so great and high-yielding investments are so scarce, that it is not surprising investors are turning to government bonds, and thus driving down their interest rate. But if the flow of funds slowed, or if the availability alternative better yielding investments were to increase, the demand for government bonds would immediately slow. Then the interest on government bonds would have to increase, if governments were to sustain their borrowing levels.

It is against this background that the budget plans to be submitted by member governments of the euro on October 15 will have to be assessed. The European Commission, in assessing the draft budgets of member states, would be unwise to assume that present low interest rates on government bonds are a permanent condition.

Ironically, while governments may defy the European Commission, they would not be able to defy the bond markets if, for any reason, bond markets were to change their minds about sovereign bonds and look for a higher interest rate. Bond markets can be less forgiving and less attentive to rhetoric or political argument than the European Commission or ministerial colleagues in the European Council of Ministers. That could happen quickly, leaving little time for adjustment.

It is less likely to happen if the EU’s system for coordinating the budget policies of the 18 euro area states are seen to be respected, especially by big countries such as France and Italy. This is backed up in a very specific way by Article 126 of the European Treaties.

If the system is defied, or reinterpreted in a way that removes its meaning, the fickle bond markets could get nervous again. Ireland knows, better than most, how difficult that can be for a state that needs to borrow to fund services or repay maturing debts.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

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