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European financial market red flags | American Enterprise Institute

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Severe economic recessions generally have their roots in excessive debt levels and financial market mispricing.

Sadly, European financial markets are now showing all too many signs of over-indebtedness and financial market mispricing. Global economic policymakers would be ignoring those early warning signs at their peril. This is particularly the case considering how large the European economy is and how vulnerable its banking system remains to financial market turbulence.

The most troubling sign of financial market mispricing is the fact that around one half of European bonds now offer negative interest rates. An extreme example of this phenomenon is the fact that the whole of the German sovereign yield curve, including 30-year bonds, is now in negative territory. It would seem that something very strange is going on when investors have to pay the German government around 0.75 percent a year for the privilege of lending it money for a 10-year period. 

The German share price index DAX graph is pictured at the stock exchange in Frankfurt, Germany, October 16, 2019. REUTERS/Staff

The fact that so many European sovereign bonds now have negative interest rates is troubling for two basic reasons. The first is that these rates indicate that the European bond market is entertaining a very gloomy view of the European economic outlook. They are doing so in the sense that they are expecting very low inflation, and possibly even deflation, to prevail over a prolonged time period. Such an expectation would seem to imply that the bond market expects a prolonged European economic recession that would lead to such low inflation.

The
second reason for concern is that negative sovereign bond yields imply that the
European bond market entertains a very different view of the European economic
outlook than does the European equity and credit risk markets. While the
European bond market is now flashing strong economic recession warning signals,
still buoyant European equity prices and tight credit risk interest rate
spreads are suggesting that European risk markets believe that the European
economic skies will remain indefinitely blue. This could be setting European
financial markets up for severe strain when they eventually re-price risk. 

Anyone doubting how badly European credit risk is mispriced need look no further than the following three examples.

The first is that even Greece, a country with a public-debt-to-GDP ratio of 180 percent and which is no stranger to sovereign debt default, now has its government managing to place some of its bonds in the market at negative interest rates.

The second is that a number of high-yield
corporate bond issuers too are managing to place their bonds at negative
interest rates. Never mind that by definition high-yield bonds are highly risky
and are supposed to bear high interest rates to compensate investors for the
default risk that they are running. 

The third and perhaps the most troubling example of European credit risk mispricing is the fact that the Italian government is now able to borrow for 10 years at a record low of 0.8 percent, or at around half the corresponding rate at which the US government can raise money. Never mind that Italy has a highly sclerotic economy, the second highest public debt level after Greece, and a rickety banking system. Never mind too that with a sovereign debt of around US$2.5 trillion, Italy has the world’s third largest sovereign bond market after the US and Japan.

It is particularly troubling that all of this credit mispricing is occurring at a time that the world economy is confronted with an unusual constellation of systemic economic risks ranging from a US-China trade war, a hard Brexit, and rising Middle East tensions. The materialization of any of these risks could trigger major European credit risk repricing. For which reason, it would not seem too early for global economic policy makers to make contingency plans for how to deal with yet another global economic and financial market crisis.



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Thanks !

Thanks for sharing this, you are awesome !