Eurozone: Contagion Pressures Intensifying

Long gone, unfortunately, is the initial wave of enthusiasm surrounding the Euro Summit of late October, when a series of initiatives to deal with the Eurozone’s problems was announced. While somewhat short on details, that announcement included an enlargement of the European Financial Stability Facility (EFSF) that had been supported by Germany’s parliament, a European bank recapitalization plan, and a proposal for a larger voluntary haircut on Greek debt. The initial stock market reaction was quite positive, with bourses around the world rallying strongly for a few days post-summit. But that was short-lived and indeed October 28 proved to be the high water market for most stock markets. Since then, continued problems in the Eurozone have led to surging sovereign bond yields across much of Europe and a November stock market decline across much of the globe, with the S&P 500 declining by -10.2%, the Euro Stoxx down by -17%, the DAX falling -15.4% and the Nikkei dropping -10.8%. Even developing economy stock markets have suffered, with the Shanghai CSI 300 down -12% in November and Brazil down -8%. Commodity-based nations have not escaped the downdraft, either, with Australia’s stock market down -9% thus far in November and Canada dropping by the same percentage.

Europe remains the epicenter of systemic risk, and the European sovereign bond market is increasingly refl ecting high levels of market disappointment and frustration with the absence of a lender of last resort, as neither a European Central Bank (ECB) nor Eurobond-oriented solution appears to be forthcoming. Having already contributed to leadership changes in Italy, Spain and Greece, the bond market is seeking the reassuring presence of a more defi nitive credit backstop, given that is unlikely that even an expanded EFSF will be suffi cient to manage contagion spreading to a larger Eurozone nation, such as Italy. Meanwhile, over the past weekend Germany, the Netherlands and Finland suggested that the International Monetary Fund play a bigger role in absorbing losses from the Eurozone as it has become apparent that the market will require a higher level of subordination in the EFSF in order to be enticed to buy bonds. But the request for IMF member nations to share more fully in the sharing of sovereign credit risk comes across as a bit disingenuous, since Germany has consistently refused to pledge more than its initial contribution of €211 billion to the EFSF and seems intent on limiting its direct exposure to Eurozone sovereign bond downside.

In what is now becoming an all too familiar pattern, European leaders unfortunately continue to take action only when the bond market forces them to. And that bond market pressure continues to intensify, with Italy bond yields breaking through 8% and German bond yields rising by 43 basis points over the past 10 days, a period during which, by contrast, yields on U.S. Treasury bonds declined by 9 basis points. Since November 15,
then, German 10 year bonds have gone from being priced 14 basis points below their US counterpart to 38 basis points above at the close of last week.

While the rise in Germany bond yields could refl ect a view that Germany will eventually have to accept the concept of a Eurobond (which would increase the fi nancial pressure on Germany, being put in a position forced to absorb what would be unlimited liability for the debts of other Eurozone nations) it is also conceivable that the bond market is sending a signal that the boundaries of contagion are wider than was once thought possible. In any event, bond markets continue to be the major driver of change, because
policy initiatives continue to be reactive as opposed to proactive. In that sense, it is conceivable that continued bond market pressures will eventually reach a breaking point and force some more defi nitive action, either through the Eurozone offi cials ultimately acquiescing that there will be a lender of last resort or through either a downsizing of Eurozone members or (less likely but not necessarily able to be defi nitively ruled out)
a potential break up of the Eurozone itself. The latter still appears unlikely, because it would probably be more costly than either the ECB or Eurozone offi cials agreeing to establish a lender of last resort (whether unlimited bond purchases by the ECB or an agreement to move towards Eurobonds). As a result, it now appears to be just a matter of time before a combination of a European recession and unsustainable bond yields across more of the Eurozone force offi cials to move closer to a more permanent solution, as the bond markets are demanding.

Meanwhile, the UK has, aside from its ongoing commitment to the IMF, largely stayed out of direct involvement in the Eurozone fray, remaining focused on its own issues and policy. UK policy has a dual emphasison government austerity and quantitative easing, in the hope that accommodative monetary policy will both refl ate asset prices and stimulate economic activity. Economic growth has been positive for the third consecutive quarter, up 0.5% in third quarter, but a key issue for the UK economy is whether it can continue to grow when one of its largest trading partners, the Eurozone, falls into what seems almost certain to be an upcoming recession.