Photograph: FREDERICK FLORIN/AFP/Getty Images
Europe

Common Euro Bonds Can Smoothe ECB's Market Exit

Centralizing bond sales would send a powerful signal about the euro's longevity.

The prospect of a halt to the European Central Bank's bond-buying program at the end of the year removes a powerful bulwark against rising government borrowing costs. Together with the rise of anti-euro parties in Europe, it has also spooked investors. Now, perhaps it's time to resuscitate the old idea of centralizing bond issuance by all euro members.

Spanish Prime Minister Mariano Rajoy revived the issue of common bond sales in comments to his domestic parliament on Wednesday:

We need to send a message of unity, hope and integration. Among other things, this means having a joint European budget that can help countries going through a complicated situation and, possibly, issuing debt jointly -- the euro bonds -- so all Europeans can benefit from better financing conditions that come with being backed up by a European treasury, not just national ones.

The benefits of common bond sales are easy to grasp. Individual bond issues would be bigger and easier to trade, the market as a whole would be deeper and more liquid, and weaker borrowers would benefit from cheaper funding as yields converged to an average level. Spain, for example, pays about 1.8 percent to borrow money for 10 years, compared with Germany's 0.4 percent rate; the gap has widened to about 140 basis points from 100 basis points six months ago.

But there are downsides too. If less creditworthy governments can piggyback off the fiscal discipline of their euro peers, the incentive for reform disappears. Germany, in particular, is horrified at the notion of lending its AAA rating to a freeloading neighbor.

And yet, the euro project needs something to silence the growing chorus of naysayers. On Thursday, for example, the Financial Times published an article with the headline "Italian Debate on Merits of Ditching Euro Grows Louder." A second article featured Michael Hasenstab, who runs a $41 billion bond fund at Franklin Templeton, who is betting against the euro because of the "not normal" situation in Europe where "people start to question the very foundation, the legitimacy of the currency."

Sentix GmbH, a Frankfurt-based company that specializes in behavioral finance, conducts a monthly survey of investor expectations about a euro break-up. While the risk remains below the peaks seen in mid-2015 and mid-2016, when Greece looked most vulnerable to an exit, it's edged higher to reach 25 percent:

Rising Risk of a Euro Break-Up

Percentage chance that a country leaves the euro in the next 12 months

Source: Sentix via Bloomberg

That recent jump in doubts about the euro  coincides with polls suggesting Le Pen can win the first stage of the French electionWhile she's predicted to lose soundly in the second leg, investors are taking the risk of an upset seriously given her threat to take France out of the euro.

Hugh Hendry, who runs the London-based hedge fund Eclectica Asset Management, is betting that Italian bonds are particularly vulnerable to a Le Pen victory, writing in his March letter to investors that he sees "a significant probability of such a political upset." In the event of a Le Pen win, Hendry sees the yield spread between Italian and German 10-year yields widening dramatically: "The upside, however, is certainly not capped at the previous 2011 high," he wrote:

Betting on Vulnerability

Gap between Italian and German 10-year yields

Source: Bloomberg

Even if Le Pen loses the election, Hendry sees the end of the ECB's QE program as a threat to Italian bonds:

Even without any political upheavals I would expect the ECB to continue to unwind their purchase program and, as the private sector is required to fund more of Italy’s maturing debt, yields will continue rising. As such we have a substantial position on the spread widening between the Italian 10-year bond yield and its German equivalent.

The euro's diminishing role in the foreign exchange reserves of governments around the world is further evidence of the common currency's fall from grace. After peaking at about 28 percent in 2009, usage has steadily declined:

Diminishing Importance

Euro as a percentage of global foreign exchange reserves

Source: International Monetary Fund via Bloomberg

It's probably no coincidence that Spain's Rajoy wants to restart talks about common bond sales in the month before the ECB scales back its bond buying to 60 billion euros ($65 billion) per month from 80 billion euros previously, as it prepares to halt the program at the end of the year. While it's impossible to quantify how much higher euro borrowing costs would be without the ECB's purchases, the 1.7 trillion euros the central bank has added to its balance sheet in the past two years has undoubtedly kept yields lower than they would otherwise be.

Common bonds could ease the ECB's withdrawal from the market. They would provide a way around the limits on which country's debts the ECB is able to buy, which is already proving problematic as it runs out of eligible German and Portuguese bonds. The move would prevent traders and investors from picking off the weaker euro members one by one by betting against their debt once the ECB isn't there to backstop yields. It would also send an important signal of determination to stick with monetary union whose flaws have become too obvious to ignore. For Germany, the risks of a common bond program pale in comparison to the risk of a euro zone breakup.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Mark Gilbert at magilbert@bloomberg.net

    To contact the editor responsible for this story:
    Therese Raphael at traphael4@bloomberg.net

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