What Next for European Interest Rates?

The market has finally received all of the relevant information that has been dominating the news. Namely, the Greek refunding and a passing of the debt ceiling in the US. After such important events the markets normally take a few days to digest and then to draw their conclusions. For treasury departments, having a wait-and-see, attitude can be critical, as the initial reaction to the Greek resolution saw peripheral countries yields fall sharply, while the safe haven status of German debt saw rates rise. However, the prevarication over the US debt situation and its unsatisfactory resolution in tackling the huge debt has seen rates reverse direction dramatically and move beyond the peaks and troughs when the Greek situation was at its worst.

The fundamental complexities involved can be daunting even for the professional trader, so here is a synopsis of what I think are the key points to remember and a set of charts that show movements in yields.

  • The Greek resolution was in effect more quantitative easing.
  • History from the 1930s shows that this is only effective if the market believes that the central banks are willing to extend this policy for as long as is necessary.
  • The market does not believe this to be true, because politicians and some policy makers in both Germany and the US refuse to accept that this is the correct path. This creates the fear that interest rates must rise, which chokes off recovery and undermines the serious house price crisis in the US. The comment from the head of the Bundesbank that the Greek bailout weakens the foundations of monetary union highlights this fact.
  • The bailout did not increase the size of the €440bn European Financial Stability Facility (EFSF), which means they acknowledge the fact that a bailout of Spain and/or Italy is not possible. This means that if those economies contract further, pressure will increase and yields will rise sharply, therefore mimicking the path of the Greek, Irish and Portuguese yields.
  • Furthermore, any increase in the EFSF would have to be agreed by the single currency members. This seems politically unpalatable to Germany.
  • While the bailout decreased the nominal interest rates that had to be paid, if the economies contract and GDP continues to fall, the net cost of repaying will actually increase. The continued fall in the bank deposits in Greece highlights the fact that ordinary Greeks have no faith in the austerity measures being forced on them, or that the bailout will lead to recovery. If this continues the prospect of a run on Greek banks is probable.
  • The raising of the debt ceiling in the US has seen yields actually fall both before and after the resolution. This implies that the market is more concerned by weakening economic growth and is discounting the probability that the US government debt will lose its triple A rating. That would normally mean rates must rise.

Below is a set of charts that visually highlight the dynamics of global interest rates. They clearly show that the fault lines in the world debt market remain elevated. Flight to quality can continue and peripherals can see debt costs rising.

The first example is Greece, where long-term rates have dropped dramatically on the bail out.

Figure 1: Greece Long-term Rates

Source: CQG

 

In contrast, two-year debt has risen more sharply since the bail out.

Figure 2: Two-year Debt Since the Bail Out

Source: CQG

 

Italian 10-year debt has now broken out above the highest rate since monetary union. Rates can rise sharply to 7.25% or 9.30%.

 

Figure 3: Italian 10-year Debt

Source: CQG

 

 

Spain is also making post-monetary union highs and the economy is struggling badly.

 

Figure 4: Spain Economy Struggling

Source: CQG

The flight to quality into German bonds continues. Rises in yields to positive news have been minimal.

Figure 5: The Fight to Quality Into German Bonds

Source: CQG

 

US yields have fallen in spite of a prospect of a downgrade, and have broken out of a sideways range that lasted for three months.

 

Figure 6: US Yields: Fallen Despite Prospect of a Downgrade

Source: CQG

 

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