Is The European Calm About Over?

by: John M. Mason

Wolfgang Münchau, in the Financial Times, asks the question, "Will the bond market vigilantes come to the eurozone and wreak havoc?" The article also contains the teaser, "there is much bad news still to come out of the eurozone."

This is the concern I have been writing about in pieces like "The Next Known Unknown: Europe?" The recent flow of money out of safe-haven markets like those for US Treasury securities and for German bunds caused the yields on government securities in the United States and Germany in May and early June to rise rather quickly.

The question hanging over this flow of funds into riskier, especially peripheral, eurozone states, is whether or not international investors will cling to their feeling that the European financial crisis is over. Mr. Münchau seems to believe that the problems are not over -- that funds may flow back out of these countries once again and "bond market nerves threaten to end Europe's calm."

He argues that one needs to understand why the money began to flow back into the lower-risk European debt. "One reason," he writes, "is that investors firmly believed a pledge from Mario Draghi, president of the European Central Bank, to provide an unlimited backstop to the eurozone's sovereign debt market."

He continues, "They also attached strong credibility to the notion of a eurozone banking union." Unfortunately, he concludes, "This, however, remains a work in progress."

"If both of these projects were for real, the eurozone crisis would indeed be over since the combination of the two would end all default risk. The ECB would guarantee the solvency of the states. The banking union would guarantee the solvency of the banks. The ECB would guarantee the liquidity of the banks. And, the banks would guarantee the liquidity of the states."

He continues, "That last point is particularly important, as banks have become the main buyers of their home nation's sovereign debt."

Even though over risks may still exist, the bond market crisis would be over!

Mr. Münchau goes on to present reasons why both of these "projects" are facing big challenges. First, the German courts are testing the ability of the ECB to carry out Mr. Draghi's "guarantee." Second, major conflicts exist within the European Union over the construction of the banking union and who will hold the responsibility to clean up the failed institutions that still remain.

The major stumbling block hindering the formation of a banking union is the concern over want institution or what country is to stand behind the hidden losses of the banks. These losses are estimated, at a minimum, to be "at about €1 trillion" and could double or triple "without appearing unreasonable."

"Add in a certain amount of sovereign debt unlikely to be repaid and you have a decade of unprecedented zombification, unprecedented default, or both in succession," finishes Münchau.

Here you have an argument for a possible reversal of money flows, a movement back into the "safe haven" investments in the United States Treasury market.

This, of course, would trigger another decline in the yields on U. S. Treasury securities. Here I would argue that one should pay special attention to what happens to the yields on the Treasury's inflation adjusted bonds.

Over the past ten days, the yield on the 10-year TIPS became positive for the first time since September 2011. This yield reached the "height" of 13 basis points. Today, they issue is trading around a positive two basis points.

This does not necessarily mean that the money has begun to flow back into the United States. This little move could just be the market re-adjusting to the major move that has taken place over the past month or so.

Still, one needs to keep their eyes open in to what happens in this area of the market.

Mr. Münchau closes his article by saying that "there is quite a bit of bad news still to come out of the eurozone itself. It is hard to overestimate the negative impact of the rise in value added tax the Italian government is considering to finance a cut in property taxes. Greece, Cyprus, and Portugal all remain on an unsustainable path. So does Spain.

What we can predict with a high degree of probability, however, is that once sovereign yields rise again, the eurozone will not be prepared."

In other words, international investors remain "jumpy." And, given the fact that European officials have not really resolved anything yet, European debt markets are still subject to more volatility. And, if money moves out of eurozone financial markets, once again, and back into safe havens like the United States, yields on US government debt will fall back and remain low throughout the summer.

As far as long-term yields in the United States are concerned, more depends on what happens in Europe than what happens at the Fed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.