The euro-zone crisis

Time to celebrate?

Government-bond markets in peripheral countries are soaring

THE squiggles on traders screens showing changes in the prices of government bonds are the closest thing that financial markets have to ECG machines for economies. By this diagnostic measure the invalids in Europes medical ward are making a remarkable recovery. On January 10th the interest rate on Spanish ten-year government bonds fell below 5% for the first time in almost a year. Even though rates then ticked up a tad, the cost of new government borrowing is now about 2.5 percentage points lower than it was when worries over a break-up of the euro area peaked in July 2012 (see left-hand chart). The Italian patient is doing well too. The rate on ten-year Italian debt is approaching 4%, which is also close to 2.5 percentage points off the highs last year. Other measures show improvement as well. Big banks in Italy and Spain are managing to sell long-term bonds. European banks also seem likely to reduce their dependence on the lifeline extended by the European Central Bank (ECB) through its long-term refinancing operations. Huw van Steenis, an analyst at Morgan Stanley, reckons that banks (mainly those in the core of Europe) may repay 100 billion -200 billion ($133 billion-266 billion) of the 1 trillion in cash they borrowed from the central bank in 2011 and 2012. Mario Draghi, the president of the ECB, says that a positive contagion is sweeping through Europe. The idea has some merit, but is the region really on the mend?

The first cause for investor optimism stems from the assurances by Mr Draghi that the ECB will do whatever it takes to save the euro. That sparked a burst of bondbuying by hedge funds that were covering short positions in Italian and Spanish debt. Id say that 80% or 90% of the juice is gone from a [euro] collapse trade, says one fund manager. Institutional investors such as pension funds and insurers are now also returning to these markets. Part of the explanation for this is that Spanish and Italian bonds still offer juicy yields, even when adjusted for the risk of default, compared with depressed rates on other assets. Mr Draghis positive contagion may also play a role. Prices of government bonds do not simply reflect the underlying health of government finances, they also influence them. In the cases of both Spain and Italy debts that appear sustainable at interest rates of 3-4% become unsustainable if rates move persistently to 6-7%, making it rational for investors to keep selling bonds even as they get cheaper. In turn, cautious investors such as insurers tend to sell bonds that display high volatility or that fall rapidly in price because these variables affect their internal measures of risk. Such technical factors can also reverse, says Andrew Balls of PIMCO, a bond-fund manager that has been buying Spanish and Italian bonds for some months now, having previously sold much of its holding. When [bond] prices are falling people want to sell, and that can also work in the opposite direction, says Mr Balls. If bond yields continue to be steady or decline, if volatility continues to be steady or declines, then youcan crowd investors in. Confidence in bond markets is being seen as a turning-point in the crisis. Yet some of the vital signs may be misleading. One worry is that the connection between weak banks and weak governments may have strengthened again in recent months. Bond traders suspect that much of the demand for Spanish and Italian government debt in recent months has come from the domestic banks of these two countries. Barclays reckons that some of this was facilitated by the recent recapitalisation of weak Spanish banks. Anecdotally one sees that when there is a Spanish holiday

[and no Spanish bond-buyers] there is a widening of spreads, says one investor. Although there are signs of revived interest from foreign investors, they seem to be buying bonds that will mature soon (and thus are potentially protected by ECB bond purchases under its Outright Monetary Transactions programme). The underlying economic picture remains grim. Germanys economy contracted in the fourth quarter. Unemployment is extremely high in peripheral countries, stoking fears of unrest. Spain and Italy risk missing their deficit-reduction targets. Small firms in both countries are suffering from a drought in bank finance; when they can borrow, they pay through the nose. Output in much of the periphery is forecast to shrink this year (see right-hand chart). Most worrying of all is that the fall in yields may blunt the incentive for euro-zone politicians to take tough decisions on reforms. European policymakers only move at gunpoint, and the only gun around is the market, says Willem Buiter of Citigroup. The fact that sovereigns take a holiday from painful decisions every time the pressure is off is one reason why positive contagion is very harmful.