Europe's debt problems haven't gone away – they've just begun
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Associate Editor
David Stevenson Sep 07, 2010
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Yesterday the FTSE 100 added another 11 points to its recent strong run.
Europe's shares were up a touch too.
Indeed the DJ Stoxx 600 index, made up of a mix of European stocks, has gained 10% within the last two months.
So you could be forgiven for thinking things are now just about all right again in the eurozone. And that the continent's government bond panics of a few months ago are history.
Sadly, that's not the case. Sovereign debt default fears are back. And this time, they could actually be worse. Here's why.
Another big problem has cropped up in Europe
Having plunged by 10% within four weeks by the end of April, shares in Europe have recouped all that lost ground since the start of July.
And why not? Company profits have been higher than forecast. Second quarter eurozone GDP expanded by 1%, with the annual rate upped to a better-than-expected 1.9%. Service sector and manufacturing activity surveys have suggested this growth will continue for the moment. And maybe most important, at first glance the eurozone seemed to have survived its sovereign debt crisis.
Earlier this year, some heavily indebted countries – specifically Greece – looked like they would default on their debts. Yet a mixture of EU bailout promises and austerity budget plans steadied the ropier bond markets and strengthened the euro.
So does this mean that eurozone countries are now saved from going bust?
Well, no. There's a slight problem. In fact, a rather big one has just cropped up.
"Looks like the celebration came too soon. The respite in Europe's debt crisis appears to have been only temporary", says Michael Schuman on Time.com. "Once again investors have come to realise that the real underlying problems of Europe's weaker economies remain generally unresolved, while the EU still has no clear agenda for resolving them".
Markets may have liked the fact that governments in Greece, Ireland and Portugal among others have started slashing their spending. But investors are also realising that the starting point for these countries was so dire that it's becoming a near-impossible task to balance the books.
For example, Portugal's combined private and public sector debt adds up to well over 200% of GDP.
In Ireland, the state of banking sector debt – used to inflate a now-burst property bubble – just seems to get ever worse as property prices continue to fall. Economists Peter Boone and Simon Johnson reckon that the Irish government will end up having to shell out the equivalent of a third of GDP to prop the banks up. "They concluded that at current ten-year interest rate levels, Ireland is effectively insolvent", says Wolfgang Munchau in the FT.
As for Greece, don't ask. In a best-case scenario, Greek government debt will swell to 150% of GDP, Pimco's Andrew Bosomworth tells Bloomberg. "Debt servicing as a share of government revenue will increase substantially, particularly if current yield levels don't decline", he says. "Greece is insolvent".
Europe's bond markets are heading for more trouble
You'd think it couldn't get much worse. But it can – and it is. European equity investors may seem more upbeat, but Europe's bond markets can only see further troubles.
"The gap in yields – the spread – between the ten-year bonds of peripheral eurozone countries and Germany has been growing at an alarming rate", says Munchau. Now it's "close to the level that prevailed before the EU decided to set up its first bailout fund in May. The spread on Ireland's bonds hit a record level after Standard & Poor's downgraded its sovereign rating in late August".
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Here's how it works. Wider spreads show that investors are becoming more nervous. The greater the perceived risk of holding government debt issued by the eurozone's peripheral countries, the higher the return – the yield – investors will demand for holding these bonds. In turn, the price of dodgy sovereign debt must fall as yields rise.
These peripheral countries need to borrow lots more money just to keep going. And the wider those spreads get, the more they'll have to pay for it. And with eurozone governments hoping to raise more than $100bn in bond auctions this month (roughly twice what they raised last month), we'll soon see just how willing investors are to lend to them.
There's "quite a substantial risk Greece eventually defaults or restructures", says Bosomworth. "The bond markets are telling us parts of peripheral Europe will end up only repaying parts of their debt", says Munchau. "I think bond markets have got this one right".
What can investors do about it?
So what's the bottom line for investors now?
Clearly, don't be fooled by the hefty yields on offer on the bonds of the countries we've mentioned above. They're not worth the risk – you could potentially lose large chunks of your capital.
And if you're feeling bold, then there's a way for you to bet on jitters about a eurozone debt default worsening. It's not simple, or risk-free, as I'll explain, but you might find it worth considering.
Last time there was a eurozone panic in peripheral debt, Germany was seen as a safe haven. So yields on Germany's government bonds fell (in other words, the price of the bonds rose). Broadly, that was enough to push up the overall eurozone bond price level.
But this time, yields on German bonds have fallen so far – to just 2.3% – that it's hard to see them dropping much more. That means the value of these bonds wouldn't rise further. So if the spreads on 'peripheral' debt now widen further, overall eurozone yields are likely to climb from here. That means lower eurozone bond prices overall.
The Luxembourg-quoted db X-Trackers II Short iBoxx € Sovereigns Eurozone Total Return (GY: XSGL) fund aims to track the Short iBoxx € Sovereigns Eurozone Total Return index. In turn, this is the inverse of the iBoxx Sovereigns Eurozone bond index, which I'll call by its market code of QW1X.
Here's what that means in English. Broadly, when eurozone sovereign bonds rise in price, so does QW1X. When they drop, the Short index gains, as does XSGL. Now any 'short' product is risky, because you're selling something you don't own – so losses can stack up pretty quickly. But if you're prepared to take the chance, and also reckon that eurozone sovereign bonds are heading for a fall, then this fund could be for you.
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