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Deja Vu In The European Bond Market

Judging by the renewed optimism in the European sovereign debt market, one could be forgiven for thinking that the worst of the European economic crisis was behind us. After all, European sovereign bond yields have now declined toward levels last seen immediately before the onset of the European sovereign crisis some five years ago. However, it would be a grave mistake for European policymakers to allow currently buoyant market sentiment to blind them to the European periphery's still very large economic and political challenges since today's highly favorable global liquidity conditions are almost certainly not likely to continue indefinitely.

A popular adage on Wall Street is that when the winds are strong, even turkeys fly. By this, it is meant that when liquidity is ample, investors do not discriminate between different credits but rather invest blindly in anything that offers an attractive yield. If ever global liquidity conditions have been highly favorable, it has to have been in the past year-and-a-half. For not only was the Federal Reserve expanding its balance sheet at an unprecedented rate to exceed US$ 4 ¼ trillion, but so too was the Bank of Japan in an effort to rid Japan of deflation.

In the context of ample global liquidity, Europe has now fully regained the market's favor despite the threat that a move to deflation poses for the European economy and despite last month's dismal European parliamentary election results, which suggested a crumbling of the European political center. As a result, we have the absurd situation in which the Italian government today can borrow at rates practically as low as that paid by the US government despite the fact that Italy's debt-to-GDP ratio now exceeds 135%.

Similarly peculiar, the French government now borrows at rates very similar to those of the German government despite the clearest of signs of France's domestic political fragmentation and despite the country's many structural economic difficulties. Meanwhile, countries like Cyprus and Portugal, which were not too long ago viewed as countries with unsustainable debt dynamics, have now been able to reaccess the global capital market with medium-term bond placements.

Before European policymakers take too much comfort in today's low government borrowing costs and before they ease up further on budget austerity and structural economic reform, they might want to ponder the following fact. On the very eve of the onset of the 2010 European sovereign debt crisis, a country with as bad as economic and political fundamentals as Greece was able to borrow at less than ¼ of a percentage point above the rate that the German government had to pay. And it did so only to find that its borrowing costs soared to prohibitive levels once global liquidity conditions changed and the market focused anew on the country's poor fundamentals.

Especially at a time when the Federal Reserve has already started tapering its bond buying program, policymakers in the European periphery would be making a grave mistake to premise their policies on the assumption that today's highly favorable global liquidity conditions will persist indefinitely. Rather, they should now be preparing for a return to more normal liquidity conditions by redoubling their efforts at structural economic reform to make their economies very much more competitive and their public finances sounder.