[Today’s Fortune & Freedom comes from The Fleet Street Letter Wealth Builder and its editor Charlie Morris, a former £3 billion fund manager at HSBC. He recently began warning about instability in the place I consider to be the greatest risk of causing another global financial crisis. I asked to republish his work, which comes in two parts. You can find Part 1 here. Today, let’s check out Part 2.]

The €10 trillion (€10,000 billion) euro area government bond market is too big to ignore. If there are problems there, there will also be problems in the euro area’s non-government bond market, which is about the same size.

There will also very likely be problems in bond markets outside the euro area – and in global equity markets.

And problems do exist. In an edition of The Fleet Street Letter Wealth Builder from 15 February 2022, we looked in detail at what has happened over the last 13 months or so to one specific bond – the Republic of Austria’s 2.1% 2117 bond.

You read that correctly. Nearly five years ago, the Austrian government – cleverly – managed to take advantage of very low bond yields and inflation rate to borrow money for 100 years at just 2.1%.

As we explained last week, the value of an investment in that bond had fallen by 41% since late 2020.

As fears of inflation in the euro area have risen, so market yields in the bond markets have gone up, and the prices of bonds have fallen.

The impact on the Austrian bond was particularly severe because there are still about 95 years to maturity and because the coupon interest rate is so low.

Nevertheless, the rise in yields on euro area government bonds (and corresponding fall in prices) has affected many other bonds too.

However, what really matters is that higher inflation is only one of the challenges facing the government bond markets.

There are other important problems.

Spreads that are too narrow – and why it matters

Austria is, and has always been seen as, a “core” euro area country – like Germany, France, the Netherlands or Finland. To differing degrees, the “core” countries have traditionally had low inflation, strong currencies, well capitalised banks, high savings rates and governments with balanced budgets.

The “peripheral” euro area economies, by contrast, are those that traditionally had high rates of inflation, over-extended banks, persistently large budget deficits or big current account deficits or a combination of these problems.

The “peripheral” countries include Portugal, Italy, Ireland, Greece and Spain.

Because the governments of the “peripheral” countries were, and are, seen as being riskier (in financial terms) than those of the “core” countries, their government bonds normally trade(d) on higher yields – and lower prices – than comparable bonds from “core” countries.

A simple way of assessing how bond investors see a particular “peripheral” government in financial terms is to look at the difference between the yield on a 10-year bond issued by that government and the yield on a comparable bund issued by Germany’s government.

The difference is called the spread. If perceptions of the “peripheral” country improve, and it is seen as being less risky, the spread will narrow (or get smaller). On the other hand, if perceptions get worse, and the “peripheral” country is seen as being riskier, the spread will widen (or get bigger).

The spreads for 10-year Spanish government bonds relative to bunds since 1993 – or shortly after the Maastricht Treaty (of February 1992), which paved the way for the introduction of the euro.

The Maastricht Treaty required that governments of countries who would become part of the euro area do certain things. In particular, the governments had to maintain “sound public finances, to ensure that they are sustainable.”

The Treaty envisaged that the member states of the future euro area would converge in terms of (good) budget management, inflation, long-term bond yields and exchange rate stability.

For a long time, the plan worked, and was seen by most commentators as working. On 10-year Spanish government bonds, yield spreads fell from almost 4.0% (or, if you prefer, 400 basis points) in mid-1995 to virtually 0.0% just three years later.

Investors were taking the (correct) view that the Spanish authorities would keep the budget deficit and current account in order, and would work to keep inflation suitably low. In addition, there was less currency risk, because the authorities were not permitted to devalue the peseta (Spain’s legacy currency) against the other currencies of what would become the euro area.

Yields on 10-year Spanish government bonds then basically remained in line with those of 10-year German bunds for a decade up until the beginning of 2008.

From that point though, spreads began to rise on 10-year government bonds in Spain and the other “peripheral” countries. Investors had begun to see a looming financial crisis in parts of the English-speaking world and took the view that, the likelihood of trouble in the “peripheral” countries was (a lot) greater than in the “core” of the euro area.

Nevertheless, by the end of 2009, yields on 10-year Spanish government bonds were still less than 1% (or 100 basis points) higher than the yields on comparable German bunds.

Then, spreads for government bonds in Spain and all the “peripheral” countries surged upwards in through 2010 and 2011. The proximate cause was the blow-out of the budget deficit in Greece from 2009. As investors became a lot more risk averse, they focused on the (different) problems across the other “peripheral” countries.

As the crisis intensified, risks of various disasters rose. These included bank collapses, defaults on bonds, economic and political chaos and… possibly… one or more “peripheral” countries abandoning the euro.

On 26 July 2012, then European Central Bank (ECB) President Mario Draghi made his famous announcement that the institution would do “whatever it takes” to save the euro. In this context, “whatever it takes” included the creation of money on a large scale in order to buy government bonds – or quantitative easing (QE).

The announcement – and the QE – worked. On 10-year Spanish government bonds, for instance, the spreads narrowed from 5.50% (or 550 basis points) in mid-2012 to 1.00% (100 basis points) at the end of 2014.

Several factors helped the ECB to restore financial stability in the euro area. Inflation was low and/or falling for much of the period. That meant that yields on 10-year bunds and other key government bonds in “core” euro area countries were low or falling. As spreads contracted on “peripheral” government bonds, the risks of defaults went down – which meant that spreads went down further. In other words, there was a virtuous circle.

Spreads on 10-year Spanish government bonds have remained fairly constant at around 1.00% since the end of 2014. Spreads widened in March 2020 amidst the general turmoil in financial markets which occurred when Covid-19 left China and became a global pandemic – but not by much and not for long.

So, the key question is this: are spreads on 10-year Spanish government bonds (and, for that matter, other “peripheral” government bonds going to stay low… or are they likely to widen/rise?

I’d suggest that the spreads are, in fact, likely to widen – and that’s another big problem for euro area government bonds. The spreads on 10-year Spanish government bonds are about the same as they were seven years ago.

However, conditions in the euro area now are very different to what they were in early 2015.

Like other central banks, the ECB is under pressure to acknowledge the problem of rising inflation, to increase official interest rates and to scale back its QE programme.

And, crucially, other investors are aware of this problem – at a time that rising inflation means that all bond markets are vulnerable to a sell-off.

This is reflected in the curtailed availability of funds to traders and investors who want to invest in global bond markets..

FINRA, the organisation that supervises broker-dealers in the United States, has published data on the availability of margin debt since 1960.

Even in the context of 62 years, the latest slowdown in the growth of margin is significant.

If the amount of margin lending actually contracts, this could prompt a new round of selling in bond markets – and a widening of spreads in “peripheral” euro area countries.

The key take-aways from all this are as follows:

  • The ECB faces a policy dilemma. Rising inflation and rising inflation expectations in the euro area suggest that it should increase its key refinancing rate and cut back on QE. However, the potential for problems in the “peripheral” countries’ government bond markets means that the ECB needs to keep it monetary policy settings very easy.
  • If there are problems in the euro area government bond markets, there will also be problems in other bond markets – including those outside the euro area.
  • High yield (“junk”) bonds, emerging markets bonds and other bonds that are seen as risky or illiquid will be especially vulnerable to a sell-off.
  • It is possible that one of the really big stories in global financial markets in 2022 is another major crisis in euro area bond markets.

Charlie Morris
Editor, Southbank Investment Research


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