When 5% is the new 6%

By Ben Turney 

Just over a year ago you couldn’t open a financial website or publication without seeing a headline proclaiming that the yields of Spanish or Italian 10 year government debt were above the “unsustainable 6% threshold”.  The popular belief was that these stricken nation states could not afford to service borrowing costs above this level and that this was going to lead to a default, precipitate a wider crash and even destroy the Euro. As the eurozone crisis peaked, all lazy journalists needed to do was a quick check of Bloomberg to get the latest bond prices and the sensationalist copy basically wrote itself… From a reporting perspective, one of the great things about the 6% threshold was that it made it easy to communicate quite how bad the situation was.

As the crisis abated however, the worst fears were not realised, bond yields dropped and the headlines went away. However, this whole issue could be about to reignite unless the European Central Bank (ECB) acts.

In many ways, the ECB has been probably the primary beneficiary of the US Federal Reserve’s largesse, which is ironic because, unless I have missed something, propping up the ECB is not in the Federal Reserve’s mandate. When Bernanke opened up the floodgates again last autumn, the immense liquidity injection sent borrowing costs tumbling around the developed nations. Prior to this, the ECB had been coming under increasing pressure to take more decisive action than it had already as it was widely recognised the measures it had in place had not satisfactorily fixed Europe’s problems.The money provided through the Long Term Refinancing Operation only had a three year lifespan and the Central Bank had refused to make direct purchases on the open market, and which was something other central banks had done in pursuing their “accommodative” monetary policies. The feeling was that all the ECB had achieved was a good deal of can kicking.

Being more charitable, it could be said that a central tenet of the ECB’s strategy was to buy Europe time to solve its glaringly obvious problems. Well, now that time is running out and there is little sign that the stricken nations have taken the necessary steps to extricate themselves from the economic mire they now find themselves in. Unemployment continues to rise, economies are contracting, structural reforms have run into serious opposition, forecasts of recovery have come to nothing and, worst of all, borrowing costs are on the up again. This last point is the most troubling.

The problem now for the ECB is that the impending withdrawal of American QE looks like it is going to force the Europeans’ hand. The market has sent a clear signal that it believes borrowing costs are going to rise. Below are the 5 year charts of Spanish and Italian 10 year government debt yields.

Currently Spain borrows at 4.79% and Italy at 4.49%. These rates are still well below the crisis levels, but as the charts above demonstrate, the recent spikes in borrowing costs have more than likely sent a shot across of the bow of Europe’s planners. The question is what can they do?

As ever, the ECB has to gain German approval before it acts. The deeply entrenched opposition of Europe’s paymasters to further QE is well documented. With a federal election on September 22^nd it seems implausible that there will be any German support for more extensive QE in Europe, not least because selling this idea to the voting public would be political suicide. 

Even so, time might still be on the side of the ECB as the German election is only two and a half months away. As long as yields don’t rise further the situation appears manageable.  Beyond this the landscape could change dramatically, especially if the Federal Reserve follows through and formally starts its process of normalising monetary policy. Southern Europe cannot afford the rising borrowing costs associated with American QE withdrawal, but a newly elected German government might just suddenly see the wisdom in relaxing its opposition to further ECB action. Looking at the charts above and it appears that the first sign of stress will be if Spanish or Italian yields do go above 5%.

At this point there seem to be two most likely outcomes.  Either the eurozone crisis could come back with a vengeance or the ECB could step in with its own QE blitz. Whatever the case, the outlook for Euro versus the Dollar at this point looks decidedly bearish.