US headlines have largely been dominated by US-centric news lately (e.g., the S&P downgrade). But to us, the bigger news is from Europe. Let’s look first at Greece—arguably the most troubled eurozone country. As discussed here, the European Council agreed July 21 to a new Greek aid plan, including a restructured IMF, EU and ECB loan valued at roughly €109 billion and voluntary private-sector participation in debt load reductions. Thus far, progress on debt exchanges for longer-term, lower-interest bonds seems to be proceeding in quite orderly fashion. There’s talk the Greek debt swap plan may need to include debt maturing up to 2024 (versus a previously stated end date of 2020). That may or may not have contributed to eurozone volatility Wednesday, but it’s likely factually rather irrelevant, as the reaction to the plan’s been fairly positive—presumably because it looks like Greece will successfully hit the €135 billion rollover target.
Portugal and Ireland—the next two to pose challenges—have also received bailouts and ECB support, including bond purchases announced last week. Since the most recent round of bond purchases began, yields on Portuguese and Irish two-year debt have fallen nearly 9 and 13 percentage points from late-July highs of 20.42% and 23.50%, respectively. (Yes, you read that right: nearly 9 and 13 percentage points.) Now, other factors are likely in play here as well—such as the Greek plan referenced above. But this should succinctly illustrate eurozone policymakers aren’t out of ammunition to confront the problems in even some of the most troubled member nations.
Spain and Italy were the next sources of concern—particularly because in the event they do encounter liquidity troubles, many view them as harder to backstop. So as rhetoric heightened, the ECB began buying Spanish and Italian debt as well—this time, unsterilized purchases, meaning they won’t remove the resulting liquidity from markets, making the program essentially a European version of quantitative easing. Spanish fears weren’t really all that new, and Italian fears, a likely contributor to recently volatile markets, seem quite disconnected from facts. Unlike other PIIGS nations, Italy’s currently projected to run a primary budget surplus and has a tiny deficit—and even that’s projected to be eliminated within a couple years. Yes, they have a lot of debt, but the amount held by foreign investors is miniscule relative to their peers, and that’s not nearly as problematic as many presume. With that being said, Italian 10-year yields have fallen 100 basis points this week, and in Wednesday’s auction of one-year bills, yields fell and demand rose from a month ago.
So it seems the actual issues pertaining to immediate consequences of peripheral debt woes are likely contained for now—but (somewhat unsurprisingly) that hasn’t calmed eurozone fears. Wednesday, rumors began circulating France is the next downgrade target in rating agencies’ sights, largely predicated on concerns both growth estimates and deficit reduction plans are overly optimistic. But the ratings agencies say France isn’t currently under review—so what’s seemingly driving concern is fear they may change their mind. Taking a step back, though, there are quite a few “ifs” involved in French worries: if growth and deficit-reduction targets are too high, if ratings agencies change their minds and review France and if, upon review, they decide to downgrade France. And above all else, S&P’s moves only really matter if, contrary to historical precedent we’ve seen again with the US, an S&P downgrade actually materially impacts credit markets. (Rates on US Treasurys continue falling and are near record lows.)
We haven’t and aren’t suggesting Europe doesn’t face challenges, or even that those challenges aren’t significant (fixing Ireland’s banking woes and other nations’ economic competitiveness is unlikely to be quick). But there’s a big difference between what’s truly negative and where fears have gone. Fresh eurozone concern seems much more a case of morphing fears in what’s continued to be a volatile, challenging and somewhat nerve-wracking market. Ultimately, however, fears exceeding reality is a primary feature of corrections—and the truth is fears are fleeting. Which is largely why corrections are too.