A dangerous spillover to other asset prices

There recent surge in the treasury yields heralds a dangerous spillover to other asset prices

There are undoubtedly lots of places where the insidious effect of rising US yields could bring untold damage. Much of this focus may be on the riskier segments of global markets, such as emerging markets or poorer credit quality assets within developed countries.

Our focus here is on the euro zone and, specifically, bond market spreads between countries in the region. The last time there was a major financial shock emanating from the US was the 2008 global financial crisis; a crisis that was followed a few years later by a debt crisis in the euro zone that nearly forced Greece from the Union and destroyed the stipulation that there could be no bailouts.

Move forward a dozen years and the twin shocks of the pandemic and the Ukraine/Russia war might not have originated in the US, but it is conceivable that the US’s response to these crises and, most recently, the surge in treasury yields, creates conditions in the euro zone that sees similar bond market stress to that seen between 2010 and 2012. This might seem a little far-fetched but it is already notable that the surge in treasury yields has seen a sharp rise in spreads between many periphery euro zone bond markets and the safer German bund market.

Now it is not the first time that spreads have risen sharply since the pandemic struck but the difference this time is that there seems to be genuine fear in the treasury market. It would not be difficult to envisage a scenario in which continued increases in longer-term treasury yields start to cast the biggest burden on periphery euro zone bond markets, potentially creating another crisis situation.

We have pointed out many times before that the euro zone bond markets are theoretically far more vulnerable than treasuries, or indeed other developed-country bond markets. That’s because euro zone countries issue their own debt but don’t print their own currency. With the printing press outlawed it means that the risk of default is far greater, as Greece and others found out just over a decade ago.

Some lessons have been learned from that debacle, such as the idea of selling more jointly-issued debt, but the region is still nowhere near to the single bond market that many critics of EMU flagged as a major flaw even before EMU started. This seemingly creates a danger that if treasury yields continue to surge we will see much bigger increases in periphery euro zone yields. Could this prospect also force the euro into greater capitulation against the US dollar?

It might but, as we’ve also pointed out in the past, the decision to keep debt issuance and currency issuance separate means that national central banks in the euro zone don’t have access to the sort of monetary financing that arguably is open to the likes of the Fed, ECB, Bank of England and other central banks that control the money supply process. The corollary of this is that, in allowing the euro zone bond market to run the gauntlet of disgruntled investors the shapers of EMU bought themselves a degree of confidence in the currency that’s arguably not replicated in other central banks unless, of course, the ECB itself decides to come over all lax when it comes to monetary policy.

We think that all this was a key reason why the 2010-12 euro zone crisis was limit ed to the bond market with relatively limit ed spillover to the euro. Coming back to today, we also think that if bond market tensions escalate to more dangerous levels in the euro zone, whether that’s a result of higher treasury yields or not, it should leave the euro relatively undisturbed.