Is The Eurozone Doom Loop Back?
The post summer rally in Eurozone bond yields has reignited concerns over the sustainability of the periphery’s debt positions, which have only grown larger because of the pandemic. While these concerns are only whispered for now, they clearly illustrate how the continent has failed to fully emerge from the specter of its decade old sovereign debt “doom loop”. What is the doom loop, and are concerns warranted?
Firstly, here’s a chart showing how yields have snapped higher recently, after falling all summer.
As you can see, 10y yields in Italy, Portugal, and Greece (the countries hardest hit in the 2011-2012 crisis) have all recovered from their summer lows; with Italy and Greece hitting new highs for 2021. However, it is also quite obvious that, at least for now, 10y yields are still some way off the highs made in March 2020, when Covid first spread across the world.
While it is too early to tell if the current move higher in yields will result in a sharp spike higher and a funding/financial crisis for the affected Eurozone economies, the recent move higher is sparking concern, especially in Italy.
Italy, by virtue of being the Eurozone’s third largest economy, and also one which is still plagued with low growth and high debt levels, serves as the bellwether for Eurozone debt troubles. The thinking goes that, should Italy begin to struggle with higher financing costs, yields in smaller Eurozone nations with high debt loads will also suffer, possibly igniting another continent-wide debt crisis which can spread to larger economies like Spain and France.
These fears are based on the continued existence of the doom loop, which links these countries’ highly indebted governments with their domestic banks. The loop exists because banks in these European countries are heavily involved in financing their own governments, which exposes them to large losses should the value of their government’s bonds fall.
When this occurs, banks have no choice but to book losses, which affects their profitability, and consequently their ability and willingness to extend more financing not just to their governments, but also to businesses and consumers in their economies. Reduced lending leads to economic contraction, which further reduces banks’ profitability and capacity to lend, while also reducing government tax revenues.
This in turn leads to even more concern in the sovereign debt markets over the affected governments’ ability to repay their debts, sparking another round of selling in their bonds, resulting in even higher financing costs and even more bank losses. At this point, should efforts to intervene fail, the negative feedback loop can take on a life of its own, ultimately resulting in bank failures, government defaults, and an economic depression.
In this context, Italian banks are the most susceptible to the negative feedback effects of the doom loop, which is another reason why higher 10y yields have sparked today’s concerned whispers.
However, at this point, such whispers are not cause for too much concern.
As the chart above shows, spreads of 10y yields of Italy, Portugal, and Greece versus Germany, while having moved higher recently, are nowhere near their March 2020 highs.
Here is a longer term chart for context:
Spreads were many times higher during the debt crisis than they are now, even with their post summer bump – which is barely perceptible when viewed within the context of the last decade.
It is important to note that the chart compares spreads, and not nominal yields. While nominal yields cannot be compared in such a manner as interest rates over the past 10 years have been trending lower all over the world; spreads can, because they are the difference between two countries’ nominal yields.
Consequently, the bond market really isn’t issuing any kind of major warning signal yet. It is entirely possible that this current move marks the beginning of the next Eurozone debt crisis, but if that were the case, we would also have to see sustained weakness in the Euro against the Dollar, and yields on UST Bills driving toward 0% as demand for repo collateral increases; which isn’t currently happening.
Until then, all we can do is watch these markets closely.
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