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With a rising tide of populism sweeping across Europe amid a string of crucial elections, bond markets once again appear to be questioning the European Central Bank’s ability to defend its currency.
In July 2012, at the height of the euro zone sovereign debt crisis, Mario Draghi famously said the European Central Bank (ECB) would do “whatever it takes” to preserve the euro. With the yield on Spanish and Italian ten-year government bonds at the time above seven per cent and six per cent respectively, calling into question whether each country could continue funding and servicing their debts, his vow arrived in the nick of time.
The remarks, coupled with his bank’s increasingly interventionist stance, provided a badly needed tonic for the currency bloc’s bond markets. By March 2015, shortly after the ECB became the last of the world’s major central banks to implement quantitative easing, those yields had dropped to 1.2 per cent and 1.1 per cent.
However, just two years later, the ECB’s success in suppressing bond yields may be in danger of unravelling. For the past nine months, bond yields have been creeping steadily higher, as shown in the chart below.
Figure 1: 10-year government bond yields
Much of this increase reflects economic fundamentals within the euro zone, particularly rising inflation: consumer prices were two per cent higher in February compared with the same month a year earlier. It is also true the ECB will be relieved inflation is no longer below its target for the first time in four years, especially since prices were actually falling just nine months ago. Even if higher commodity prices have played a bigger role than stronger economic growth in forcing inflation up, the central bank will be encouraged that fears deflation was taking root appear to have been banished, at least temporarily.
However, it will be altogether less content with the second factor behind the jump in yields: rising political risk. As a growing tide of populism sweeps across continental Europe – and in the wake of the unexpected results of the UK referendum and US presidential election last year – markets are suddenly alert to the threat of the euro zone breaking up once more. And unlike five years ago, when concerns centred on Greece and other peripheral countries, investors this time around are looking closely at countries with some of the region’s largest economies, including France and Italy.
With crucial elections taking place this year, risk aversion has returned. As the chart below shows, the spread between ‘safe-haven’ German government bonds and other European markets has risen appreciably since last summer.
Figure 2: 10-year bond yield (spread vs Germany)
A few eyebrows would have been raised in January, when for the first time Draghi implicitly conceded a splintering of the currency bloc was possible. In a letter to two Italian lawmakers in the European Parliament, he said any country leaving the euro zone would need to settle its claims or debts with the bloc's payments system before severing ties.
However, according to Aviva Investors’ chief European economist Stewart Robertson, while it is natural that markets should be worried, talk of the euro collapsing appears unduly alarmist.
“There’s actually a lot more harmony in the euro zone than there has been at various times in the past. It’s certainly not going to break up imminently. And even then, it’s a big if,” Robertson says.
While some of the widening in bond spreads seen in recent months is explained by fears negotiations over the next tranche of Greece’s €86bn bailout could turn sour, or that the difficulties plaguing the Italian banking sector could worsen, the bulk stems from mounting uncertainty over the outcome of forthcoming general elections.
Those worries persist, despite the result of the Dutch election on March 15, when prime minister Mark Rutte saw off a challenge from the far-right Partij voor de Vrijheid (PVV), or Freedom Party, of Geert Wilders.
With many commentators having seen the Dutch vote as a litmus test for the strength of anti-establishment populism ahead of elections elsewhere in Europe later this year, European Union (EU) officials’ relief was palpable.
“A vote for Europe, a vote against extremists,” a spokesman for EU Commission chief Jean-Claude Juncker tweeted.
However, Juncker’s contentment was not shared by bond markets, with yields rising in the immediate aftermath of the result becoming clear. Geoffroy Lenoir, Aviva Investors’ Head of Euro Sovereign Rates, says there was little cause for relief, since Wilders was never going to get into power as most of the mainstream parties had ruled out cooperating with him.
He believes that even though the spread between ten-year German and Dutch government bond yields has risen to 25 basis points from just ten a year ago, the risk premium is unlikely to fall.
“It could take a few months to form a viable government. Arguably this political uncertainty has not been completely priced in,” Lenoir says.
A win for Wilders was to have been the third domino to fall in a series that could yet include a win for Marine Le Pen’s National Front (FN) in France, a strong showing by the anti-migrant Alternative für Deutschland (AfD) in Germany – and the possible disintegration of the EU.
Certainly, ahead of the vote, Rutte had cast the Dutch election in that light, saying that following the upsets of Brexit and Trump he saw it as the “quarter-final” in a five-round competition, in which “the semi-finals are the French elections, and the final the German election”.
In the event, with 95 per cent of the votes counted, the PVV looks set to win just 20 of the 150 seats in the House of Representatives, a gain of eight from the previous election in 2012. While that would mean it was the second biggest party in the Netherlands’ lower house, the result falls short of what had seemed likely at the start of 2016, when the party was riding high in the polls.
Robertson says the PVV’s failure to make much headway partly reflects a backlash in Europe against both the UK vote to leave the EU and the election of Donald Trump.
“If anything ‘Brexit’ and Trump has led to a little bit more solidarity among the remaining EU and euro zone members,” he explains.
However, both he and Lenoir believe it would be unwise to read too much into the Dutch result. Although the far right in France and Germany – which would no doubt have hailed a Wilders victory – may be disappointed, it is not clear the outcome will actually have much bearing on their own prospects. After all, despite loudly welcoming both Brexit and Trump as the beginning of a patriotic revolution, the FN and AfD saw no improvement in their polling afterwards. Just as support failed to rise then, it is not clear it will drop now.
“The main concern for European bond markets has always been the French election. It’s not obvious there are many parallels with the Dutch vote,” says Lenoir.
France goes to the polls on 23 April, when voters will be asked to choose between what looks like being five or more candidates. Should none secure a majority of the votes, as seems virtually inevitable, a run-off election between the top two will be held on 7 May.
Opinion polls suggest the candidates of both the Socialist and right-of-centre Republican parties, which have dominated French politics for most of the post-war period, are likely to be eliminated in the first round. Le Pen and centrist candidate Emmanuel Macron, who has established his own grassroots party 'En Marche!', are the surprise frontrunners.
Le Pen has said that if elected she would launch a referendum on France’s EU membership within six months in order to give the country control back over its currency, debt and trade policy.
However, while she may win the first round, it seems unlikely Le Pen will be able to draw sufficient votes from the defeated first-round candidates to prevent Macron, or a candidate from the Republican party, from winning the second. Polls suggest Macron would comfortably defeat Le Pen by a margin of around 60:40 in a two-way run off.
“We reckon Le Pen has no more than a ten per cent chance of becoming president,” Lenoir says.
Nonetheless, it seems many investors are unwilling to take a chance on the result. French bond yields have risen sharply relative to German bunds in recent weeks, reflecting growing unease at the risk of Le Pen upsetting the odds.
The spread between ten-year German and French yields recently hit a peak of 82 basis points, up from 45 at the start of the year and just 30 a year ago, although it has since declined to currently stand at 63.
“Without the election we should be closer to 40 basis points. But foreign investors will remain reluctant to buy French assets until they have a clearer picture of the next government,” Lenoir says.
The preferable outcome for the bond market would be for François Fillon or another Republican candidate such as Alain Juppé to emerge victorious as there would be less political uncertainty. The problem is that neither looks capable of doing so.
Fillon is under growing pressure from lawmakers in his own party to step down. Having once styled himself a sleaze-free “Mr Clean”, he now finds himself at the centre of a full investigation by judges into an alleged misuse of public funds and a list of other potential offences. Although he denies breaking the law, his poll ratings have plunged.
Juppé – the former prime minister defeated by Fillon in the battle for the Republican party’s nomination in November –says it is too late for him to step back in to the fray.
If Macron were to win, is that it is unclear what support he would get from parliament and what kind of reforms he would be able to push through since he has no party behind him. Lenoir describes a Le Pen victory as “the nightmare scenario” for bond markets, which he believes would suffer devastating losses across Europe as investors switched into German bunds.
Lenoir argues that while he would expect the OAT/bund spread to almost immediately widen by as much as 200 basis points, in reality it would be extremely difficult for investors to value bonds for some time.
“They would have to focus on two different things. Firstly, will the ECB buy (bonds) to contain the widening? The answer is not so obvious. And secondly, if Le Pen is elected president, will she be able to form a government?”
Lenoir believes that with the FN currently boasting just two deputies in France’s 577-seat lower house, there is no more than a one-per-cent chance of Le Pen winning the presidency and her party simultaneously securing a parliamentary majority.
This means she will not be able to ask for a referendum to exit the EU and the euro zone. To do so she needs to change the constitution, which contains the phrase ‘The Republic is part of the European Union’. In any case, it is not at all certain French people would wish to do either.
“For the time being, around 65 per cent of French voters are happy to keep the euro, although whether that changed if Le Pen got in remains to be seen,” Lenoir says.
As for Germany, polling for September’s federal election suggests the race between Chancellor Angela Merkel’s Christian Democratic Union and the resurgent opposition Social Democrats is too close to call. Much attention has focused on the AfD, which polls suggest could harvest around 10 per cent of the votes; enough to give it several seats in the German parliament. However, it is expected to be shunned by establishment parties and locked out of talks to form a governing coalition.
Further political uncertainty could be triggered if Italy holds an election, as seems increasingly likely after the country’s highest court in January effectively devised a new voting system, favouring a form of proportional representation approved by former prime minister Matteo Renzi.
Italy's largest parties - Renzi's Democratic Party (PD) and the anti-establishment 5 Star Movement - are both calling for a vote by the summer, about a year ahead of schedule.
Both the 5 Star Movement, which leads opinion polls, and the far-right Northern League, have floated an exit from the single currency. Meanwhile, former prime minister Silvio Berlusconi’s centre-right Forza Italia, which is fourth in the polls, has proposed a new parallel currency. Only the ruling centre-left PD is willing to defend euro membership.
Lenoir says an early election would be likely to see the spread between Italian and German government bond yields widen “appreciably”.
However, Robertson and Lenoir both conclude that although it is understandable bond markets should be nervous, it is unlikely the far-right will assume control in France, Germany or Italy.
“There is a danger markets are getting ahead of themselves, even if doubts over the euro’s long-term chances of survival remain as valid as ever,” Robertson says.
A new euro crisis?
That latter point is echoed by Des Supple, founder and chief executive officer at Event Horizon Research, a London-based macroeconomic consultancy advising investment businesses. While the euro zone is unlikely to collapse imminently, Supple insists it remains in a perilous position.
“Monetary expansion put the crisis in abeyance by artificially supressing the price of credit risk. But it didn’t resolve it,” he says.
He argues that Germany’s view on what is required to resolve the crisis is getting ever more inconsistent with the view of ‘non-core’ countries such as Italy and Spain.
“Germany, which fears inflation is in danger of taking off, continues to favour a deeply deflationary path to restructuring the rest of Europe. But it’s a defunct scenario, with more aggressive fiscal austerity than economic rationality demands and the rest of Europe can bear,” he says.
Supple is especially concerned tensions between Germany and others are rising at a time when monetary easing has helped engineer a welcome upturn in the euro zone’s economic fortunes. The danger, he says, is that tensions will intensify if and when the next economic downturn arrives. And he warns that may not be far off, with the recent rise in oil prices having begun to hit real disposable incomes.
Many commentators argue the only way to hold the euro together permanently is for member countries to form a fiscal union, with richer nations transferring money to poorer ones. However, Robertson says such an agreement appears as elusive as ever.
“History suggests they will need to be on a precipice before anything is likely to get done,” he says.
Supple is even more sceptical. The problem, he says, is that the rise of nationalism seen across the euro zone doesn’t lend itself to such an outcome. Regardless of the results of this year’s elections, the populist backlash is unlikely to disappear in a hurry.
“Wilders said ‘regardless of the result the genie will not go back into the bottle’ and it’s hard to disagree,” Supple says.
Five years ago, Draghi, with his “whatever in takes” mantra, successfully called financial markets’ bluff by daring them to bet against the bank. In doing so he bought politicians some badly needed time to put the euro zone on a more solid economic footing. But as he also made clear shortly after, there were limits to what the ECB could achieve on its own. In order to create the fundamental conditions for bond risk premia to disappear, politicians needed to push ahead “with fiscal consolidation, structural reform and European institution-building with great determination”, Draghi said.
With politicians still struggling to enact the kind of remedies he had in mind fast enough, it seems bond markets may once more be in the mood to question the ECB chief’s claim the euro is “irreversible”. Much rests on how the European political situation unfolds in the coming months.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 17 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
The following investment professionals contributed to this article