One union under multiple yields
A client posed the question a few years ago during one of the many rolling sovereign credit crises then roiling the Eurozone as to when the whole thing would fall apart. The answer was, “Never.” The Eurozone elites could never admit an error of that magnitude. Plus, the construct actually worked well for Germany as the euro kept its exports competitive in a way the Deutsche mark would not, and kept its domestic borrowing costs low as flight capital from the Eurozone’s periphery depressed bund rates. Most importantly, no one had a good idea of how to execute an amicable divorce.
The euro can be thought of as a fixed exchange rate among the European Monetary Union’s (EMU) 18 member countries. Once we accept this, it follows that each member country’s short-term interest rates, yield curves and fixed-income volatilities have to swing about to absorb the stresses resulting from perceived changes in credit quality.
One of the Eurozone’s central battles with reality—alluded to in the founding Maastricht Treaty of 1992 but then ignored in practice—is the fiction that all of its members could be forced into having the same credit quality if only they adhered to some arbitrary standards of budget deficits, debt-to-GDP ratios and the like. In reality, different countries have different credit ratings and different cultural attitudes toward debt, official corruption, tax collection, etc. This is not meant to disparage any country; it is almost the definition of a different national culture and why the geographic expression of “Europe” has so many small countries instead of one large one.
Much of the cultural history of Western Europe has been a longing for the single political entity lost with the collapse of the Roman Empire in the West in 476 A.D. Get over it, already.
Differential yield curves
Governments may like to have their cake and eat it too, but reality asserts itself early and irrefutably on occasion. A government or central bank can fix an exchange rate or it can fix a short-term interest rate, but it cannot fix both simultaneously. As the fundamental equation for currencies has the forward currency level as a function of the spot rate and the short-term interest rates of the two countries involved, you are left with a single equation and three unknowns. This is why currencies can move around so much; there is no one single price that clears the system but rather a large number of spot rate and interest rate combinations.
If a government pegs the exchange rate in a currency board system as Argentina and Bulgaria tried for much of the 1990s, it has to raise or lower it short-term interest rates fairly actively to maintain that peg. This becomes annoying for both borrowers and lenders, to say the least. If a country fixes a short-term interest rate, as the United States did in December 2008 or as Japan first did in March 2001, the currency will have to swing about as external interest rates change. This also becomes annoying, in this case for importers and exporters. As everyone in the economy is either a borrower or lender and is involved in international trade via the purchase of imported goods if nothing else, it is easy to see how schemes to manage currencies become everyone’s business rather quickly.
Both the stronger and weaker credits within the EMU see their yield curves respond to the Eurozone’s various stresses. We can measure this by the forward rate ratios between two and 10 years (FRR2,10) for each nation’s sovereign debt. This is the rate at which we can lock in borrowing for eight years starting two years from now, divided by the 10-year rate. The steeper the yield curve, the more the FRR2,10 exceeds 1.00. An inverted yield curve has a FRR2,10 less than 1.00.
We should expect weaker credits’ short-term interest rates to rise and flatten their yield curves during times of stress as these countries need to compensate for their greater risk. Conversely, we should expect stronger credits’ short-term interest rates to fall and steepen their yield curves during times of stress as risk-averse investors seek a refuge. This has happened with great regularity in the Eurozone, especially since the sovereign credit crisis began in late 2009. The movement of national FRR2,10 since the euro started turning lower in May 2014 illustrates this phenomenon well (see “Seeking refuge,” below).