Potential investors in Europe’s sovereign bond markets may feel they have stepped into Alice in Wonderland. Many sovereign debt markets are offering return-free risks, and negative bond yields make a mockery of traditional explanations of the time value of money. What we are seeing is the end result of two powerful but opposing forces within Europe that reflect the chaotic responses to the global financial crisis.
The ECB is attempting to use quantitative easing to drive down bond yields right across the yield curve, with the explicit objective of increasing investment into riskier assets to stimulate the European economy. But the regulatory environment in the form of Solvency II and Basel III is assigning often penal capital requirements for investing in riskier assets than government bonds, whilst pension funds with a focus on solvency are also encouraged to match liabilities with bonds, irrespective of yields.
As a consequence, Europe has achieved the perverse situation where its regulatory environment and its economic strategy have totally conflicting objectives with the net result that bond yields do not reflect any fundamental assessment of value. Whether there is a bond bubble now existing may be debateable, but I suspect that no one will be investing in government bonds for their grandchildren.
Meanwhile, the Greek tragedy continues and Grexit, whether voluntarily, forced or by accident, is a real possibility. Particularly so as the implications of Grexit today are far less worrying to the rest of the EU than they were three years ago. But it would be a lose-lose situation for both Greece and the rest of the EU.
Greece itself undoubtedly would have been better off had it defaulted on its private debtors five years ago. That, however, would have had a calamitous impact on the rest of the euro-zone. But as it transpired, the northern European banks that were most exposed to Greece were saved through the intervention of national and supranational lenders.
The population of Greece, however, saw little benefit from that manoeuvre. Unfortunately, Greece’s population has been let down for decades by a political class that failed to develop a modern European state. The reaction to this has been the election of a government led by a hard-left coalition with little practical experience of governance, and which is strong on dogma but no more likely to develop a modern European state than its predecessors.
It might be economically acceptable if the EU allows Greece to fail now but it could well destroy the political vision that ultimately holds the EU together. The ramifications of that may be uncontrollable.