Europe's Credibility Gap

Spanish (and other) bond yields whipsawed back and forth, money poured in and out of safe-haven assets, and the U.S. stock market gyrated back and forth. The forces behind these moves are nothing new. The market's fear gauge continues to move up and down based on an assessment of how willing and able European institutions are to stem the crisis.

Jeremy Glaser 13 August, 2012 | 0:00
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Spanish (and other) bond yields whipsawed back and forth, money poured in and out of safe-haven assets, and the U.S. stock market gyrated back and forth. The forces behind these moves are nothing new. The market's fear gauge continues to move up and down based on an assessment of how willing and able European institutions are to stem the crisis. Until these institutions are able to convince the markets, once and for all, that they have the crisis under control, the volatility isn't likely to stop.

The gauge was sky-high earlier in the week as Spain remained in laser focus. Continued issues in regional governments, a huge number of unanswered questions about the pending bank bailout, and concerns about a further slowing economy sent 10-year bond yields over the 7% level. And it wasn't just long-term debt that was getting hammered; short-dated bonds took a beating, too. As Morningstar's corporate bond strategist Dave Sekera pointed out, the hefty yield on the two-year bonds indicated the market was beginning to believe that a near-term default was becoming more likely. With high short- and long-term borrowing costs, Spain could find itself in a situation where it becomes very difficult to refinance debt that is coming due. This would exacerbate the country's financial situation and send rates even higher.

With the fear of higher rates in mind, European Central Bank head Mario Draghi waded into the market on July 26th to say that the ECB was ready to do what it needed to in order to keep the euro together. Draghi promised that the central bank has the firepower to keep the situation under control. Add in some supportive comments from German chancellor Angela Merkel and French president Francois Hollande, and the talk was enough to send markets higher and bring Spanish debt off the edge. Investors are hoping that this talk turns into an ECB-led sovereign bond-buying program that will keep borrowing costs at reasonable levels as peripheral countries make the fundamental reforms needed to get their economies back on track.

Been There, Done That
This is not the first time that the market had cheered an apparent breakthrough. Just a few weeks ago, there was a fair amount of excitement around the possibility of bailout funds being funneled directly into struggling banks, without adding to the already-hefty debt loads of sovereign nations. But that deal began to look shaky almost as soon as it was announced. It appears that hammering out the details between all of the stakeholders was easier said than done. There just isn't a clear consensus about how the bailout money would be distributed and who would ultimately be on the hook for it. The uncertainty about what the bailout would eventually look like was enough to send investors heading for the hills again. The pattern of initial excitement followed by disappointment is one we've seen time and time again during the crisis in Europe. From Greek elections to countless EU summits, the market seems to take a breather hoping that the continent has found its footing, only to find the progress made ethereal.

There is no reason to believe at this point that the ECB isn't going to follow through in the short term and act in the coming weeks to bring down the yield on Spanish bonds. But it is important to note that so far there has just been talk; no action has been taken. Draghi's statement was bold, but what exactly did it mean, and how far will he politically be able to take his actions? Will the ECB defend yields below 7% no matter what? What would cause the bank to back away from its commitment? What happens when politicians in Spain, Greece, or elsewhere don't cooperate with the ECB's reform agenda? Suffice it to say, there is no easy answer to these questions, and the ECB officials themselves likely don't know exactly what they are going to do. We can hope that the action is successful, but past experience shows that it is unlikely to live up to initial expectations.

This highlights one of the emerging problems in solving the crisis: the growing credibility gap between what policymakers say and what actually gets done. After years of policymakers saying they are going to take the substantive steps needed to solve the debt crisis and bring growth back to Europe, precious little, apart from a few Band-Aids, has been done. Leaders must close that gap if they have any hope of creating the foundation needed to truly fix the underlying competitiveness problems in the eurozone. The market needs to believe that leaders are going to be able to convert their words into tangible actions.

There is no magic bullet that will solve this crisis and no single move that will suddenly erase the sovereign debt woes. In a best-case scenario, we'll still be talking about these issues for years to come. But if European leaders could act with more decisiveness and deliver on their promises, it would go a long way to reducing volatility and pave the way for a return to normalcy in the markets.


Jeremy Glaser is the Markets Editor for Morningstar.com.

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Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.

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