Getting Ahead of Themselves

Investors' unrelenting quest for return, wherever in the world they can find it, has led some away from the US debt markets, where yields on even longer maturities have once again fallen well below 3%, and where the prevailing strong sentiment is that any further significant rise in bond prices is unlikely.

In recent months, they have turned their attention to the European continent. A sense that the worst of the sovereign debt crisis is over, and that even the weakest of the euro economies - along the fringe of the Mediterranean - are stabilizing, underlies a return of capital into these governments' debt markets. There is no clearer example of this trend than Greece, the country that at the depth of the debt crisis was forced to give up even trying to issue new bonds after their prices fell so far that yields exceeded 40%. On April 10 this year, Greece returned from its bond exile and sold 3 billion euros of 5-year notes to yield 4.95%, an offering that was some seven times oversubscribed, and whose yield has subsequently dropped even lower, to 4.75%, as demand has further boosted the notes' price. The Bloomberg Bond Indexes show that Greek bonds provided the highest returns year-to-date among more than 30 sovereign debt markets. And other periphery euro countries are experiencing similar demand for their debt. Thus, Portuguese 10-year securities were sold this week (for the first time since 2011) at an average yield of 3.575%, compared with a peak of 18.3% at the beginning of 2012; the government is planning on regaining full market access by next month, when its euro rescue program from the EU and the IMF ends. Spanish and Italian yields have likewise dropped to 8-year lows.

But there is a real question regarding the sustainability of this debt rally. Investors who are bidding up European bond prices seem to be focusing on the improvement in euro-government annual budget deficits. These have indeed fallen substantially. Data released today by Eurostat, the region's statistical agency, show that for the euro area as a whole, the government budget deficit to GDP ratio fell to 3.0% in 2013 from 3.7% in 2012. Of course there is considerable fragmentation between countries, with annual deficits in the periphery countries still well above 3%, although even here, the trend in most cases is sharply down from earlier years. But other figures from Eurostat also released today suggest that Europe's debt crisis is far from over. Overall outstanding debt levels continue to rise, from extraordinarily high levels. Thus, the total debt to GDP ratio in the 18-member euro area increased from 90.7% at the end of 2012 to 92.6% at the end of 2013. And the picture for the periphery countries is even more stark: Greece's debt ratio was 175.1% in 2013, compared to 157% in 2012; Ireland's debt ratio jumped from 117.4% to 123.7% over the same period. Even the debt burden of some of the region's larger economies (except Germany) is growing: the level in France grew from 90.6% in 2012 to 93.5% in 2013.

The danger here is that with massive and still growing debt levels, but with suddenly renewed access to the debt markets, governments especially in the periphery euro countries will have much less incentive to continue with fiscal policy discipline - always politically unpopular - and instead fund any shortfalls through more borrowing. They may even feel less compelled to initiate the long-term reforms of their labor markets and tax regimes so essential to the resumption of productivity and overall economic growth. In this case, it's easy to envisage another decade in Europe of sluggish growth at best - with little or no improvement in double-digit unemployment rates - and of debt levels which at some point once again become unsustainable.