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The Bond Column

European Yields
Updated: 2015-03-02, 08:56:29 ET
Analyst: David Kelland

Since the nadir of the European crisis in 2011 and 2012, the sovereign debt of Europe's peripheral nations has rallied dramatically. These are the changes in the spreads between those nations' 10-year government notes and the 10-year Bund since the beginning of 2012:

- Greece: -2,501 bps
- Ireland: -643 bps
- Italy: -554 bps
- Portugal: -1,457 bps
- Spain: -373 bps

A small part of these moves may have come from a lessening of the liquidity premium that German Bunds commanded during the crisis and some speculation that Germany would return to the Deutsche mark (implying an immediate upward revaluation of the Bund's face value, the opposite of what Greece's creditors fear in the case of return to the drachma).

The vast majority of the convergence of these countries' 10-year yields with German 10-year Bund yields, however, has come from a reduction in implied credit risk. The convergence between peripheral yields and core yields represent the bond market's gradual acceptance that Greece's debt may be restructured (as implied by is current 10-year yield of 9.29%), but that every other country will be kept on a sustainable debt trajectory.

The buying of peripheral sovereign debt is rational in light of the Eurozone's obvious commitment to holding the monetary union together, but it is also rational because the ECB, via LTRO (long-term refinancing operations) and OMT (outright monetary transactions), has set off a positive feedback loop in sovereign borrowing rates (or at least arrested a negative one). If a country grows at 2%/year, has a debt/GDP ratio of 0.9, and has to pay 4% interest on its debt, it is an arithmetic truth that the debt is not sustainable. The obvious unsustainability of the debt burden then leads investors to sell the bonds, making the problem even greater and eroding confidence in the affected economies. Readers may recall discussion during the climax of the crisis about Italy's debt cost tipping points.  

The ECB's unconventional policies, including buying member nation's sovereign bonds, have set this mechanism into reverse. Every basis point drop in a country's borrowing costs improves the country's budgetary position and therefore its creditworthiness. The more debt investors buy, the safer that debt becomes (up to a point). 

What we have seen over the last six months is that despite the Eurozone's slide towards deflation, the sovereign bond yields in the Eurozone's periphery have continued to decline. Prior to the ECB's unconventional policy measures, deflation may have meant death spirals for those economies, akin to the 1997 Asian crisis, but worse because there would be no sharp currency devaluation for countries like Spain and Portugal to export their way to recovery. 

This perception that the Eurozone will inevitably muddle through the crisis has been reinforced over the past few weeks with the four-month extension of Greece's bailout. Debt of the European periphery rallied dramatically as a deal seemed more and more inevitable. These are the changes in the spreads between the 10-year sovereign debt of the PIIGS and 10-year Bunds since February 10th:

- Greece: -103 bps
- Ireland: -29 bps
- Italy: -28 bps 
- Portugal: -44 bps
- Spain: -29 bps

Barring a serious change in public opinion in Germany (the Bundestag approved the bailout extension with 541 out of 586 votes), the can will be kicked down the road and someday Greece's debt will eventually be restructured, but at a time when the write-downs will not cause panic in Greece's banking system or the Eurozone at large, if that is possible. 

It's very late in the game to consider buying Spanish 10-years just to pick up 98 basis points over German Bunds, but, there is something rational about what is happening. Furthermore, the Euro's severe devaluation since May of last year may give Europe the stimulus that it requires. If Europe does recover and shake itself of deflationary forces, peripheral sovereign yields may climb higher anyway, as investors seek higher yielding assets and concern themselves with inflation.