Markets blew up the bunds and helped Greece

The new ECB headquarters in Frankfurt, Germany.
Wolfgang Rattay | Reuters
The new ECB headquarters in Frankfurt, Germany.

Bond traders' "short of a lifetime" – an overdue correction since mid-April of the bubbly German bond market – has brought down the yields on the Greek ten-year government bond by 135 basis points to 10.75 percent last Friday – one of the lowest yields in a highly volatile Greek market since the Coalition of the Radical Left Party (the Syriza) came to power last January.

That was a nice piece of yield arbitrage, especially since it also came with Jean-Claude Juncker's (president of the E.U. Commission) bear hug of the previously shunned Greek Prime Minister Alexis Tsipras. To top it off, Juncker made a stunning statement that Greece's euro zone exit "was not an option" during his high-profile speech (in French) at the Belgium's Université catholique de Louvain on May 4, 2015.

An added bonus is an apparently constant dialog between Mr. Tsipras and the German Chancellor Angela Merkel about Greek economic and political reforms to pull the country out of the deepening poverty and, hopefully, onto some kind of a sustainable recovery path.

All that begins to look like Europe is finally putting its oxymoronic "austerity growth model" to the side.

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But Greece's friendly bear hugs from Brussels and the supportive dialog with the German chancellor did not come easily. Months of Europe's arrogant hostility had to be overcome by Greek diplomatic efforts to raise the issue of the country's economic survival to E.U.'s highest political levels.

That's done now. Europe is relenting. Some space is opening up to conduct reforms while alleviating the crushing burden of poverty on the most vulnerable segments of the Greek society.

ECB's complex task

These objectives are at the core of difficult negotiations within a somewhat friendlier political environment. Financial markets are reading that correctly: By selling German bunds and buying Greek paper they shaved off a significant part of an excessive risk premium on the Greek government debt.

To be sure, any further progress toward an interim solution to Greece's acute debt problems will be slow and difficult. But do take heart. Markets seem to be increasingly focusing on euro area's improving cyclical conditions, Greece's anticipated reform measures and the European Central Bank's (ECB) strong support of bank lending to businesses and households.

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The ECB remains at the center of these events as it continues to nurse back to health a recession damaged financial system, which was further degraded by excessively harsh fiscal policies. The banking union has now given the ECB the supervisory and regulatory authority it needed to operate a more effective mechanism of credit management.

It is a long way to recovery, but some progress is being made. The fact that bank loans to finance mortgages, consumption spending and business investments virtually stopped falling in the first quarter of this year is a sign that the ECB is making some headway – even though these numbers are compared with their dismal levels in the first three months of 2014.

Here is how the ECB's policy process is unfolding. In March, for example, the largest increase (2.5 percent) in bank lending went to euro area governments. Buying default-free public sector bonds is part of the banking system's attempt to rebuild the capital base and improve balance sheets. That, in turn, is expected to make banks more willing – and able – to go back to their core business of financing household consumption, residential investments and business capital outlays.

As mentioned earlier, some of that is happening, but the progress is still painfully slow. Loans to households in March were flat (compared with the year earlier), but that is still an improvement on a 0.2 percent annual decline in February. The housing loans eked out a 0.2 percent increase (following no change in February), and lending to businesses declined 0.6 percent after a similar drop in the previous month.

This shows that a meaningful and sustainable economic recovery in the euro zone is still some time off. There is some recovery of consumer spending in a fully-employed German economy and in a few other countries, such as France and Spain, where the fiscal adjustment has been eased considerably. However, a rebound of business investments is nowhere in sight; sales are weak and there is plenty of idle production capacities. Indeed, the industrial output in February (the latest data point available) was weak or depressed in Germany, Italy and France – economies which account for two-thirds of the monetary union.

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The ECB, therefore, has still plenty of work to do to stabilize the financial system and to create conditions likely to trigger and sustain growing credit flows to the real economy. And its work is doubly difficult because it is dealing with largely unreformed welfare states of another era, rife with widespread rigidities in product and labor markets.

Investment thoughts

Bond traders may well have another go at the euro area's overpriced bond markets. After all, a country whose public debt accounts for 80 percent of its economy may be getting off a bit too lightly with a 0.55 percent interest it pays on its ten-year loans.

The euro area equities look much better. Given the early stages of the recovery and zero interest rates, equities still have a strong tail wind.

It is also possible that Europeans might get their act together by putting an end to their killing fields and throwing out their impediments to trade. The fact that China is coming by "belts and roads" should give them pause for thought. Today (May 11), the Chinese President Xi Jinping is talking business in Minsk, Belarus, where China is building that country's infrastructure and a huge industrial park to serve as one of the Silk Road hubs.