European Bond Spreads
THERE IS A TABLE IN THE FINANCIAL TIMES that everyone ought to follow, though it refers to fixed interest securities and moves rather slowly. It is something I regard as a thinking point. It portrays one of the core relationships of global finance, and it is always worth asking oneself why the relationships are what they are, and why they have moved as they have moved.
The table is to be found of Page 37 of the FT for April 2, and is always to be found on the page labeled “Market Data,” along with global equity prices, volatility indexes, and variegated statistics. It is labeled “Ten Year Gov’t Bond Spreads.” It lists the yields on 21 different government bonds, all with a 10-year life.
It gives the spread based on German bonds and on U.S. T-Bills, but its greatest interest is that it gives a Germanocentric view of the world. It makes very clear the central role of Germany in the eurozone, just as the deutsche mark had a central role in the Exchange Rate Mechanism before the European currencies, or most of them, converted to the euro.
Conveniently, the 10-year German bond, denominated in terms of euros, is the strongest of the euro bonds, and the only one that currently has a yield below four percent. The range of euro bonds is quite wide, though they are all an expression of the same currency. The most expensive euro bond is the German, which yields 3.96 percent; the cheapest is the Greek, which yields 4.46 percent.
That is precisely 0.5 percent above the German yield. I do not know who fixes this market, but it looks as though someone does, and they do it in the interest of the euro as a currency. The German-Greek spread is remarkably stable. There seems to be an underlying determination not to allow the spread to widen to the point at which the euro itself would be threatened.
Clearly, the Greek bonds are overvalued in terms of long-term risk. There is no risk at all that Germany will have to leave the euro — certainly no foreseeable risk. I suppose some explosion of the oil market might threaten the whole eurozone, as the oil shocks of the 1970s caused global inflation. But apart from that, one would have to invent terrorist fantasies to create a scenario in which Germany might be forced out of the euro system.
Not so with Greece, which has the weakest of the euro currencies. If Greece was not a member of the eurozone, Greek interest rates would presumably be higher than the six percent of Australia or New Zealand, on any normal financial criteria. Moreover, this applies to a tier of southern European countries in the eurozone. Greece yields a half percent above Germany, but Italy is very close to that level, at 0.47 percent, as is Portugal. Only Spain, at 0.28 percent, is level with a central eurozone country such as Austria.
The risk that is being underpriced is the risk of two Europes. Politically, two Europes could come into being if German and British policy were to diverge, on the issue of federation — the next British government may be more anti-federalist than the present one — or in response to competition for oil supplies. Financially, the two Europes could come into existence because the southern four — Greece, Italy, Spain, Portugal — could no longer stand the strain of a high-priced euro.
At present, I would not myself put the two Europes as a very high risk, either on political or financial grounds. But the risk is there, and it is almost certainly underpriced, because of intervention, presumably by sources close to the European Central Bank. On a 10-year view — and these are 10-year bonds — I would put the two Europe risk as significant. The Lisbon Treaty, which Britain will ratify without the government daring to have the promised referendum, will raise the two Europe risk, rather than reduce it.
Lord William Rees-Mogg
April 7, 2008