The Defeat Of The Euro Bond Vigilantes?

by: Antonio Fatas

Paul Krugman has written many blog posts downplaying the fears of a sudden increase in US government bond interest rates (what he calls the invisible bond vigilantes). Despite continuous warnings by some market commentators about the risk of high inflation and the possibility that investors start dumping US government bonds, interest rates on these bonds have gone in the opposite direction and are now lower than when some of these fears were first expressed.

In Europe the evolution of interest rates for governments bonds has been very different with several countries seeing very high levels and in some cases no access to funding. The fear was due to probability of default and potentially an exit from the Euro area, not so much inflation. But after a volatile period and following the statement of Mario Draghi supporting the Euro (no action yet), and the more recent agreement for funding for Greece and Spain, interest rates are coming back to levels which are not far from the historical average during the Euro period (and significantly lower than what these countries faced before joining the Euro).

Below are 10-year government bond rates for Spain and Italy.

Click to enlarge

Rates remain higher than the low values of 2006 but they are at levels which are not far from what we had seen in the early years of the Euro. Of course, this does not mean that the level of confidence is the same as those years, for that we want to measure the premium relative to German bonds, where we will see higher levels. But, at the same time, what matters for sustainability of government debt is the interest rate that a government pays and not its relative value relative to other countries.

There is still plenty of uncertainty in both of these countries and I am almost sure we are not done with swings in confidence and some negative surprises but it is good to see that, at least measured by these rates, there is a growing sense of stability in financial markets.