A similar narrowing of spreads happened in the run up to the creation of the single currency and the launch of Economic and Monetary Union (EMU) in 1999. During that period spreads narrowed until there was virtually no difference between yields on, for example, Italian debt and German debt.
The first phase of EMU led to convergence because countries gave up monetary policy sovereignty. To put it harshly, they gave up the ability to get themselves out of economic difficulties by devaluing their currencies (either by inflating or actual currency depreciation).
The glory days didn’t last
Spreads stayed low between 1999 and 2007. However, the financial crisis exposed a major weakness of EMU – it had been designed without the mutualisation of sovereign risk. The rapid deterioration of government finances exposed the concerns that investors had that some countries might not be able to finance themselves. The European debt crisis became severe because it was obvious very quickly that if one sovereign ran out of money there wasn’t a clear cut mechanism for supporting it.
The decline in spreads since last September tells us that, for now, the market is giving Europe the benefit of the doubt. If this second phase of convergence is to be completed – i.e. to lead to a further sustainable narrowing of sovereign spreads – there will have to be a much more transparent mechanism for the abdication of a large part of national fiscal policy.
Again, to put it harshly, countries should not have the ability at the national level to get out of economic difficulties by increasing budget deficits and public debt.
The abdication of fiscal sovereignty at the national level has to be replaced with some strong mutualised central institution that provides the creditworthiness for government bonds across the whole euro area. Investors have to be sure that if they buy bonds issued by individual governments then the ability to repay is backed by the full resources of the euro area.
We are some way away from a central fiscal authority or mutual sovereign borrower. To get to that situation there are huge political barriers to overcome and a renewed support for greater political integration that is not currently evident in the fragmentation of the political consensus in many countries.
For now, I see scope for spreads to continue to narrow as long as investors think that Europe is moving towards more fiscal integration and that national governments stick to their side of the bargain. Clearer ways of mutualising sovereign debt and actual improvements in fiscal stability should mean that sovereign credit spreads get a lot lower, even if they don’t permanently ever get back to the levels of the glory days.
The trend is our friend
The monetary convergence phase of EMU generated huge gains for holders of peripheral debt. The stuttering beginning of the fiscal convergence process has brought some substantial gains already to those that either maintained their exposure to these assets through last year or had the foresight and risk appetite to buy in H2 2012. At the moment my view is that there are more gains to be made.
What the last three years has made clear is that EMU can’t exist with full national fiscal freedom. The markets won’t allow it and EMU can’t survive in its current form with it. We are on the road to further mutualisation of sovereign credit risk and that means current credit risk premiums are too wide.
Of course, I could be wrong and it could all take a much worse direction again – there is certainly a lot of event risk – but for the time being I look for these trends to continue.
Chris Iggo is the chief investment officer for fixed income at Axa Investment Managers
