A recent research note from Societe Generale highlights an important question in Europe:
Q1: After the Greek tragedy, are long-term rate levels sustainable for Italy, Spain and Portugal?
Since the summer, significant measures have been taken by the ECB and European governments to contain the crisis. As a result, yield spreads tightened markedly. But over the past weeks, the Spanish 10-year yield edged towards 6%, while the German two-year government yield went back into negative territory. As long as Spanish funding issues remain unresolved, yield spreads between southern economies and 'safer' countries will remain wide. This may explain why Moody’s downgrade of France last week only had a minor impact on French OAT rates. Given the large refinancing needs of Italy and Spain in the next years, a rise or even a stabilisation of rates would not be sustainable.
The question here is not whether the ECB can sustain its bond buying programs. After all, central banks don’t "run out of money." And so long as the central bank backstop is there, private bidders should continue to populate eurozone bond markets. But the real question is whether the ECB’s bond buying programs are politically sustainable? How long can Europe continue to backstop these peripheral nations?
Thus far, it’s become clear that European leaders absolutely aren’t going to let the euro collapse. I think the Germans understand the domino effect that would occur if they let one nation leave. That is, if Greece leaves the eurozone, devalues, defaults and begins to recover (due to revaluation and huge gains in competitiveness), then there is a potential for other nations to follow. Germany wants to stop that before it occurs because it creates huge downside risk for the German economy via bank defaults and competitiveness issues (the euro would surge against these new peripheral currencies). So, the euro is being held together and I think Germany has no choice but to continue to lead the charge on that front.
But the downside risks to economic growth will remain as long as there is no fiscal transfer union of some sort. I’ve discussed this quite a bit in the U.S. in recent months and the same thing needs to occur in Europe. There is simply no choice. With a single currency and inherent trade imbalances there must be some sort of supranational entity that can take from the rich and give to the poor because there is no trade rebalancing via the currency. Markets won’t rebalance on their own, and at the end of the day the real problem is more structural than anything else. Greece isn’t going to become super productive like Germany. But Germany needs solvent Greek customers to buy its output. But a true fiscal transfer union looks like something that’s far off in the future. It’s just not politically feasible at this point. And that means the euro crisis is likely to linger.
And if the politicians aren’t going to push for rapid change, then the main risks comes from outside the government. SG highlights the key risk:
Risk: Rising Social Unrest
-- The job reductions planned by private companies in the manufacturing sector are significant in several European countries, including Germany.
-- The unemployment rate in the euro area has reached historical highs (11.6% in September) with dramatic rises, particularly in Greece and Spain.
-- A large wave of anti-austerity strikes has swept through many European countries, illustrating the general public’s growing discontent.
Governments need to recover some support to restore consumer confidence and boost output.
So the real question isn’t whether the euro can be held together with these temporary band-aids. The real question is how long will the public sit idly by while depression continues to ravage their economies? Obviously, there’s no clear cut answer to that question. European leaders are increasingly hesitant to move toward a true fiscal transfer union (and break-up is currently out of the question). This creates continued substantial risk of social unrest. And that’s the primary risk to peripheral bond yields. So, yes, low bond yields are sustainable so long as the public doesn’t force real change. But the more important question is: How long will the people continue to put up with depression/recession? My guess is some negative catalyst has to occur in the coming years that will force this crisis into a true resolution.