Eurozone Risks Return to Fore


The recent turbulence rattling global bond markets is unmasking an unpleasant notion in Europe: The eurozone’s problems aren’t solved.


A climb in Greek bond yields reflects renewed euro-zone caution.

Government bonds have recently taken a hit around the world, now that investors are preparing for the possible end of central banks’ boundless economic stimulus. And those bonds of the weakest euro-zone countries have shown some of the biggest drops.

That suggests that the bonds of Spain, Italy, Portugal and Greece might be susceptible to bigger swings in the future, as the flood of cash that has poured into financial markets recedes, leaving their economic warts more exposed, market participants say.

Thanks to the European Central Bank’s pledge to support markets—and to the ocean of cash from central banks—those bonds saw extraordinary rallies for the better part of a year. But in recent weeks, the course has shifted somewhat.


Yields on the 10-year Greek bond, which had strengthened remarkably since last summer, ended Thursday at 10.03%. That is two percentage points higher than where they stood on May 22, when the U.S. Federal Reserve signaled its giant bond-buying program might slow this year. At 6.47%, the Portuguese 10-year is more than one percentage point above its May low. Bond yields rise when their prices fall.

The 10-year Spanish bond, which was near 4% in early May, closed Thursday at 4.61%, flat on the day. The Italian 10-year, a hair stronger Thursday at 4.35%, also is off over the month. The spread—or the amount of additional yield investors demand, above that paid by benchmark Germany—also has risen for both countries over the period.


To a degree, the rising yields reflect the same tidal forces that once pulled them down: Easy money drew investors to those bonds; its possible end pushes them away. The rally was “more technical than fundamental,” says Carl Norrey, head of European rates securities at J.P. Morgan in London. “I can’t help but respect it, but I don’t see how Europe gets out of the crisis this easily.”

Behind the problem is a macroeconomic euro-zone picture that has deteriorated, not improved, during the period of falling yields.

“The liquidity dynamic is unfavorable, and you have to frame that in the context of these markets having extreme social, economic and political risk,” says Gregor Macintosh, head of global sovereign debt at Lombard Odier Investment Managers in Geneva, which has $42 billion in assets under management.

Mr. Macintosh has been paring his exposure to Europe’s weaker countries over the past month. “The reality is that the underlying fundamental situation is still gravely worrying in these countries,” he says. “In a crux, you have to be nimble.”

To be sure, the rally in weak-country bonds has been impressive, despite the slide of the past month. Last summer, Spain and Italy were facing a dire situation: so little demand for their bonds that they risked needing to turn to their euro-zone peers for help. The euro zone isn’t in that situation today, and the ECB’s summer pledge to step into markets if needed remains potent. The euro zone’s politics are still thorny—Germany holds elections in the fall, which have stirred up anti-euro sentiment—but the bloc’s crisis management is improved.

“German elections aside, things are far less bad than they’ve looked for some time,” says Bill Street, head of investments for Europe, the Middle East and Africa at asset manager State Street. He points to signs that trade imbalances are righting themselves and a possible plateau in the euro zone’s lofty unemployment rates. The debt of a weaker euro-zone country, with its extra yield, he says, “still holds a place in a diversified portfolio.”

But economic pressures, especially gross domestic product that has fallen faster than expected, have heightened concerns about the countries’ debt burdens. Debt that grows too fast, relative to the economy, is the principal risk for most of Europe’s weaker states—and for their bond investors.

“With Spain and Portugal, if you look at debt-sustainability models, you are going to need much higher growth,” Mr. Street says.

Italy, Portugal and Greece all have especially high ratios of debt to GDP. Spain, which began the crisis as a low-debt country, is on its way to being a high-debt one. By next year, Italy’s debt-to-GDP ratio will reach 132%, while Spain’s will hit 97%, according to the European Commission. That compares with 127% and 84% in 2012.

Arresting the rise is exceptionally hard in a shrinking economy, and European authorities have begun to reckon with this by slowing the pace of fiscal cuts, in the hopes of supporting economic growth.

But a larger problem may be looming: In order to restore their economic viability, weaker countries must improve their industries’ competitiveness by pushing down wages and other costs, relative to Germany and other northern countries. But the German economy appears to have settled into a pattern of low growth and low inflation.

That means Italy, Spain and the others need more of this so-called internal devaluation. And devaluation makes it harder to pay down debt.

Spain and Italy “need prices to rise less rapidly than in Germany to rebuild competitiveness, but they need a measure of inflation to ensure debt sustainability,” says Simon Tilford, chief economist at the Center for European Reform, a nonpartisan London think tank. “Something has to give.”

Many economists say the solution will have to take the form of higher demand and inflation in Germany, large-scale debt restructuring in southern Europe, or sharing debts at the European level. But the euro zone’s creditor countries reject all of those options, leaving no clear way out of the debt crisis.

A version of this article appeared June 14, 2013, on page C1 in the U.S. edition of The Wall Street Journal, with the headline: “Rising Bond Yields Rekindle Euro Fears.”