The rout in European financial markets last week was a watershed event. What we witnessed was not necessarily the beginnings of a bear market in equities or an uncertain harbinger of a future recession. What we saw — at least here in Europe — is the return of the financial crisis.
Version 2.0 of the eurozone crisis may look less frightening than the original in some respects but it is worse in others. The bond yields are not quite as high as they were then. The eurozone now has a rescue umbrella in place. The banks have lower levels of leverage.
But the banking system has not been cleaned up, there are plenty of zombie lenders around and in contrast to 2010 we are in a deflationary environment. The European Central Bank has missed its inflation target for four years and is very likely to miss it for years to come.
The markets are sending us four specific messages. The first and most important is the return of the toxic twins: the interaction between banks and their sovereigns. Last week’s crash in bank share prices coincided with an increase in bond yields in the eurozone’s periphery. The pattern is similar to what happened during 2010-12. The sovereign bond yields have not quite reached the same dizzy heights, though Portugal’s 10-year yields are almost 4 per cent.
The combination of high bond yields, expansionary fiscal policies, persistently high public and private sector debt and low growth rates is clearly unsustainable. Italy’s position may be better than Portugal’s but it is still not sustainable. Italian 10-year yields rose to more than 1.7 per cent; German yields are a little over 0.2 per cent. The gap, or the spread, is the metric of stress in the system, which is rising again.
The financial markets are telling us that they are losing faith in Mario Draghi’s pledge of 2012 when he promised to do “whatever it takes” to defend the member states of the eurozone against a speculative attack. With this promise the ECB president ended the first phase of the eurozone crisis, but did so at a cost. The urgency to resolve the underlying structural problems suddenly disappeared.
The second message is that Europe’s banking union has failed. The banking union the EU ended up with was a foul compromise: joint bank supervision and a joint resolution regime, but no deposit insurance and no government backstop to bail out failing lenders.
It is no coincidence that bank share prices collapsed just as the European Bank Recovery and Resolution Directive entered into full force. The directive sets out a common bail-in mechanism for a failing bank. Italy applied this law last year in the bailout of four regional banks, causing losses to bondholders. Investors in other banks fear that they, too, may be bailed in. One of the reasons why investors in Deutsche Bank began to panic last week has been the large amount of contingent convertible bonds (cocos) issued by the bank. If the bank were to run into trouble these would convert into equities, and be immediately wiped out if a resolution procedure were to kick in.
The third message is the market expectations of future inflation have suffered a permanent shift. The ECB is taking market-based estimates of future inflation seriously — perhaps too seriously. Its favourite metric is an inflation rate for a horizon of five to 10 years away from today. That measure last week fell to its all-time low of just over 1.4 per cent. It is telling us that the markets no longer believe that the ECB will hit its inflation target of less than 2 per cent even in the long run.
The fourth message is that the markets fear negative interest rates. This is because the vast majority of Europe’s 6,000 banks are old-fashioned savings and loans: they take in deposits and lend them out. The banks would normally adjust the rates they offer to their savers in line with the rates the ECB charges them, maintaining a profit margin between the two. But if the ECB imposes a negative rate on the banks, this no longer works. If the banks imposed negative rates on savings accounts, small savers would take their money and run. The banks could, of course, reduce their reserves at the central bank and lend the money instead. Or they could invest in risky securities. But that prospect is not necessarily reassuring to bank shareholders either, especially if they do not see good lending and investment opportunities.
Looking back, the cardinal error committed by the European authorities was the failure in 2008 to clean up their banking system after the collapse of Lehman Brothers. This was the original sin. Many other mistakes subsequently compounded the problem: pro-cyclical fiscal austerity, the ECB’s multiple policy failures and the failure to create a proper banking union. It is interesting that every single one of these decisions was ultimately the result of pressure brought by German policymakers.
(Copyright The Financial Times 2016)
