The big bad market

Posted by Andrew Pegler

What does it means to hear the market is “deserting” or “attacking” a particular European country?

In other words how and why is the market giving countries like Greece and Italy – and increasingly France – such a hard time? Well just like the GFC before it, Europe’s woes all come down to debt, except this time it’s public sector or government debt. Most of these problem countries (you can add Spain and Portugal to the above list) are running deficits, which are financed by borrowing, largely from the private sector.

This financing works as follows: banks and other private sector players, known collectively as the dreaded “market”, buy government bonds that pay a prescribed interest rate, known as a yield, for a fixed period of time, known as the term. At the end of the term, known as maturity, the government returns the money to the bond buyer, i.e. it repays its debt.

Under normal circumstances this works just dandy. When a government needs money it issues bonds. The market knows the yield in advance (the profit) and knows it can’t lose on the investment (because governments pay their debts, right?).

But now the market is becoming increasingly panicked/terrified/spooked (choose your dramatic descriptor) at the possibility that some of these countries won’t repay their bonds. All of a sudden those guaranteed investments are becoming high risk. And as the investment truism goes: the higher the risk, the higher the return. In return for taking on increasingly risky government bonds, the market is demanding higher yields as compensation.

For example, the recent Italian attempt to raise funds in a bond auction went so badly that their five-year yield rose to 7.8%. That means the Italian government is borrowing at 7.8%. Six months ago the yield was 3.5%. This is big cheese. An upward tick of 1% in bond yields can cost a government billions in extra interest payments.

But it goes much further than a bigger interest bill. European economies are stagnant. Unemployment and welfare costs are up. Taxes are down. Savage cuts aimed at reigning in deficits just exacerbate the problem by further depressing the economy and further shaking market confidence, which drives up bond yields even higher.

It’s a vicious cycle that now has Greece’s one-year bond trading at yields of over 300%. And the fear of contagion – one country’s collapse leading to another – is even making it hard for the poster child of prudence, Germany, to raise money.

That’s what happens when the market “deserts” or “attacks” a country – or countries. It gets ugly, fast. And in the case of Europe, pretty soon, something’s gotta give.