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Europe’s Most Indebted Countries Aren’t Ready for Market Reality

(Bloomberg) – Europe’s better economic outlook as Covid-19 vaccinations pick up is also hastening the timetable to a new danger.

As investors gear up for the burst of growth, they are also preparing for the inevitable consequence: withdrawal of emergency funding from the European Central Bank. For the most indebted economies in the region – including eternally striking Italy – they would come face to face with market forces they cannot handle. Citigroup Inc. is bracing for a tapering of bond buying as early as June, and M&G Investments says it is time to start shorting peripheral debt.

Due to the dramatic measures taken by the ECB over the past year, financing costs in the euro area have never been more disconnected from risk. Much of the region is emerging from its worst recession since at least World War II, deficits have soared and debt levels are at an instant high.

Still, an investor who lends money to Italy for 10 years can expect only about 0.75% interest. Greek bonds, considered a junk asset by all three major credit rating agencies, have an interest rate of less than 1%. Ten years ago, the eurozone debt crisis pushed interest rates above 40%.

“You only get a temporary credit risk in European countries when you are in an emergency,” said Eric Lonergan, a money manager at M&G. “The problem is, when you get out of trouble, you’re back to the market forces in your bond market and some of these numbers look really, really bad. Europe is ironically vulnerable to recovery. “

The increase in euro area debt is largely due to the ECB’s pandemic purchase program for a 1.85 trillion euro ($ 2.2 trillion) pandemic, and it has helped fill investors’ wallets. In the past year alone, Italian bondholders have posted returns of more than 10%, according to Bloomberg Barclays Indices. For more than a decade, they would have nearly doubled their money.

“The country is able to refinance debt at much lower yields thanks to the ECB, so the crisis is a bit of a blessing in disguise for Italy,” said Hendrik Tuch, NL’s head of fixed income at Aegon Asset Management. “Low yields and spreads on Italian government bonds are not realized in Rome, but in Brussels and Frankfurt, which is the main problem for the long-term outlook for Italian government bonds.”

Story continues

While ECB President Christine Lagarde said this week that it would be “premature” to talk about easing aid, the debate about what to do and when could quickly draw closer. Some policymakers are ready to argue at the June meeting that the pandemic emergency purchase program should be scaled back in the third quarter, Bloomberg reported Friday, citing officials familiar with internal deliberations.

Read more:

ECB officials expect heated June decision on crisis program Lagarde says ECB does not discuss stimulus phasing out Bloomberg Economics: Lagarde’s optimism suggests fewer PEPP purchases after 2Q

Despite Lagarde’s reassurances, such talks will raise investors’ attention on doomsday. Without emergency aid, the focus will return to debt in Greece, Italy and Spain, which has exploded further in 2020 due to necessary health and crisis expenditure, and whether it can ever be brought under control.

At PGIM Fixed Income, which manages approximately $ 968 billion, Robert Tipp, head of global bonds, is leaning towards peripheral bonds he has had since the sovereign debt crisis, but is also starting to worry about the post-taper outlook.

“The risk is how fraught is the process of moving from this harsh stimulus environment back to one of fiscal fairness,” he said. “The fundamentals are bad for some of these countries.”

For now, the member states of the European Union are preparing to spend money from the bloc’s recovery fund as they start paying out cash in the middle of the year. Italian Prime Minister Mario Draghi, the former president of the ECB who saved the euro during the latest debt crisis, plans to redesign the Italian economy with more than € 200 billion in funds. will generate sustained growth strong enough to meaningfully clear Italy’s huge mountain of debt, currently about 160% of economic output. Fitch Ratings warned this month that the Greek debt-to-GDP ratio would remain above 200% this year and that failure to reduce it could lead to a negative rating action.

Another important question is when the EU could reintroduce the tax rules – which were suspended during the pandemic – and what form they will take. While the fiscal position needs to be addressed in some countries, overly strict targets, for example on deficits, could do more damage than good by sucking life out of economies.

Saxo Bank A / S is one of the largest ominous parties on the periphery of Europe and warns that a sovereign debt crisis part 2 could arise, starting with an exodus of foreign investors from Greek debt, where they own 90%. Saxo is concerned that with US bond yields 60 basis points higher than at the start of the year – and with currency hedging becoming more favorable – investors will prefer to put money into them rather than higher-yielding European government bonds.

For the ECB, the unwinding dilemma will once again cause it to grapple with the euro area’s inherent challenge of determining monetary policy for 19 countries with widely differing economic situations, inflation, unemployment and debt. If it starts to shrink, the peripheral countries will be the ones to lose, making their massive deficits harder to finance.

“It’s very difficult to see anything other than tax cuts,” said M & G’s Lonergan. “I don’t know when it will hit, but I think you have very, very good opportunities if you look at many of the more vulnerable parts of the European bond market right now.”

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