Nothing else has changed: between December and January there was no progress on structural reforms, no big pronouncements from the European Central Bank, no big change in the economic data.
Spreads of Italian and Spanish bonds over German Bunds are now back to levels not far from where they were in early 2011, just before the Greek private sector involvement – in other words, a default – was announced.
Is this a structural change with investors finally deciding that the risks of a eurozone breakup are nothing to worry about, or is it simply a cyclical shift due to better global growth prospects? For the sake of the eurozone, it may be better if the sentiment is cyclical.
A cyclical factor could be that fixed income investors are worried about rising interest rates in the core European countries.
Although there has been some divergence, yields on core bonds are still very correlated with US Treasuries, and most investors expect US Treasury yields to rise.
Rising yields mean lower bond prices and lower or even negative returns. Rising US yields may push up yields in the eurozone core and periphery, but at least the higher interest rate in the periphery provides more offset.
Much of the peripheral debt in recent months has been bought by the domestic banks of those countries.
For the banks it seems like a pretty obvious trade: with non-performing loans at historical highs, their troubled governments are viewed as not as risky as firms and households, and if their government defaults, the banks have bigger things to worry about.
So the banks earn the high interest rates and hope to make more money if the spreads tighten, as happened over the last year.
Arguably, these banks are behaving like the Japanese “zombie banks” of the 1990s: lending to government instead of lending to households for spending or firms for investment so that the economy can grow.
As investors become habituated to, or used to, the risks of the eurozone but nothing goes disastrously wrong (except for Greece), they stop worrying about it. This takes the pressure off politicians, so no progress is made on the necessary reforms.
Hence why it may be better if investor faith in the periphery is cyclical: the complacency risks building up the next leg of the crisis because no progress is being made. And progress is most definitely still needed.
Plenty of people may wonder if the eurozone crisis is over: the economy is growing again, borrowing costs are low, fiscal austerity has been put in place, and economic imbalances are correcting.
If you talk to an economist, they may well agree that the worst of the crisis has been resolved, but as always with economists, he or she will point out that on the other hand it would be premature to say that the crisis is over.
The first stage of the crisis was about stabilising the debt trajectory and that has been achieved, but the second stage where debt needs to fall is still to come. Handling the impact on the economy will be a severe challenge.
Many countries still look fiscally unsustainable. Just as when someone goes to a bank to apply for a loan, the lender needs to consider whether the burden of the loan repayments is too big relative to their income. But even a highly indebted person’s debt may be sustainable if their income is growing quickly.
For example, if the interest payments on someone’s debt cost them 5 per cent of their income every year, but their income is growing at 6 per cent every year, their income is outgrowing their debt. The same is true for countries. If their interest payments relative to GDP are lower than the growth of nominal GDP, then the country is outgrowing its debt.
It is not too surprising that the periphery countries are the ones whose interest payments exceed their trend nominal GDP growth.
The likes of Ireland, Spain, Greece and Portugal will be forced to borrow in order to meet their interest payments – which quickly becomes a vicious spiral as interest will need to be paid on this new debt.
To avoid that, these countries must run a primary surplus (higher revenue than expenditure excluding interest payments) that is at least large enough to pay for the interest that they cannot outgrow.
There are four ways for a country to move from being one that has the potential to outgrow its debt burden to one forced to borrow.
The first and in principle best way would be to move horizontally to the right by increasing its potential growth rate.
If only it were that simple – any country that knew how to do that would have done it by now. Well, actually most countries know that they can eventually achieve this through structural reform, but are unwilling to do it.
The second way is to move vertically down through austerity: run a sufficiently large primary surplus that you can use to start repaying your debt.
Repaid debt no longer pays interest, so the interest burden should fall (unless your fiscal austerity results in an even lower growth rate). The third way is to move down by reducing the rate of interest that you pay. Countries can do this by borrowing from their neighbours (as the periphery did) or having their central bank buy the bonds (as the US and UK did).
The fourth way is to cheat: default on your debt and the interest payments go away. This is not costless – once you have defaulted you will have to continue to run a primary surplus because it will be a long time before anyone is willing to lend you any money.
Assuming that there is no default, relying on just one of the first three options is unlikely to be successful.
Growth reforms take time, austerity is painful, and some interest will have to be paid. A combination of all three is likely to be most successful, but it will still take time.
Most of the periphery has paused in both growth reforms and austerity. In those circumstances, are investors really wise to lend to them so cheaply?
Joshua McCallum is senior fixed income economist at UBS Global Asset Management. The views expressed here are his own.
