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Bond Markets

Falling Interest Rates in Europe Aren’t Great News

The national flag of Italy flies outside the Quirinale Palace in Rome

Photograph by Alessia Pierdomenico/Bloomberg

The national flag of Italy flies outside the Quirinale Palace in Rome

If very high interest rates are bad for Europe, then very low ones must be good, right? Seems logical. Yet the big drop in yields on government bonds of Italy, Spain, Ireland, and Portugal isn’t entirely positive, especially for the European Central Bank.

Here’s why: Rates are dropping because markets have lost faith in European leaders’ ability to spur economic growth, while retaining confidence that Europe won’t let governments default on their debts. In other words, bond prices are rallying on the prospect of an era of slow growth coupled with heavy-handed government intervention.

As reported by Bloomberg News, yields on two-year notes issued by the Italian and Irish governments today touched their lowest levels since Bloomberg began keeping records in 1993. Italy got down to just over 1.1 percent, and Ireland to around 0.8 percent.

Interest rates fall when the economy is weak because fewer people and businesses are interested in borrowing. Also, the European Central Bank is more likely to cut the short-term rate it controls in hopes of stimulating loan demand. For Europe, the latest bad news was an unexpected decline in a German purchasing managers’ index. “The data is sufficiently weak to up the pressure on the ECB to cut rates in June,” Lena Komileva, managing director at G+ Economics, wrote today in an e-mail to Bloomberg. “The only question is why the ECB has not cut rates already.”

Interest rates jumped in 2011 and 2012 when investors worried that big countries such as Spain and Italy might fail to pay back their government borrowings. But the risk of that subsided last year when ECB President Mario Draghi vowed to do “whatever it takes” to keep the euro zone intact, and the ECB adopted programs to back up his promise.

It’s good that investors are willing to lend to the likes of Italy and Spain at affordable rates. It’s not so good that they’re doing so at least in part because of an implicit guarantee by the European Central Bank. European bond markets would be healthier if rates reflected more closely the creditworthiness of the various nations. At this stage, a rise in rates might actually be preferable—if it reflected growing confidence in Europe’s ability to grow and prosper.

Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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