The business sections of this weekend's newspapers understandably focus on last week's disappointing stock market performance (the worst in two months for the S&P) and another round of credit downgrades for European sovereigns (Belgium, Hungary and Portugal). Yet, these are essentially lagging indicators. The stories that may well materialize in the next few weeks will be more heavily influenced by what happens this week to Europe's latest yield curve inversion, core bond rates, and policy announcements.
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Curve inversions are often seen as indicative of a potential tipping point—when market perceptions of a liquidity problem risk turning into self-fulfilling solvency concerns. As such, there is nothing good associated with last week's curve inversion in Italy, the third largest bond market in the world.
With the 2-year interest rate on Italian bonds surging towards 8%, the yield differential with the 10-year ended the week at an inverted 60 basis points. Judging from what has happened in other European economies (namely, Greece, Ireland and Portugal), a prolonged inversion would materially increase the risk of Italy losing market access and having to seek a bailout.
Last week's disappointing news out of Europe was not limited to the highly-indebted economies. There were also notable, albeit less dramatic developments in the bond markets for core governments, including powerhouse Germany
The yield on bunds, the German 10-year bonds, widened from 1.97% to 2.26% (implying a 30 basis point differential with the US). Damage elsewhere in the core was more extensive, including an additional 28 basis points deterioration in French 5-year CDS to a previously unthinkable level of 250 bps (mid). This took the widening so far in November to a staggering 74 bps for this AAA credit.
The longer it takes to stabilize Europe's core bond markets, the greater the risk that capital flows within the Eurozone (namely, from the periphery to the core) may become swamped by flows out of the region as a whole, thereby threatening a region-wide credit crunch, triggering further rating downgrades, and undermining consumption, investment and trade.
These developments accentuate the pressures felt by markets that are already straining to function normally (see my previous post). It is therefore critical for Europe, and more broadly for the global economy, that they be reversed quickly.
This brings us to the third area of focus for the new week. The next few days will see a number of important policy announcements on and out of Europe. These go well beyond some EUR 15 billion in debt issuance by countries under market pressure and the run-up to the monthly ECB meeting on December 8th.
Some of the key annoucements relate to positioning in the run-up to yet another European Summit on December 9th. Others involve the potential augmentation of a key emergency financing facility—the EFSF—together with possible co-financing with the ECB and IMF.
Well crafted announcements (and related prior actions) can normalize the Italian yield curve and stabilize the bond market for core countries if, as I have argued before, they involve simultaneous progress in five key policy areas: designing more appropriate reform programs for highly-indebted economies; providing for a more credible delineation between the region's liquidity cases and solvency ones; countering the deepening fragility of the banking sector; strengthening the institutional underpinning of the Eurozone, whether in its current configuration or a new one; and instituting a durable circuit breaker for what has been a continuous deterioration in market technicals that destroys private demand for European bonds.
So, while last week's nearly 5% loss in the S&P 500 was the worst Thanksgiving-week losssince 1932, it is critical to stay on top of what is happening elsewhere. With a number of important announcements coming up this week, the well being of many economies and markets around the world depends on European policymakers being able to reverse the additional damage incurred last week, particularly in Italy and core markets.
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Dr. Mohamed El-Erian is CEO and co-CIO of PIMCO, the bond investment house.
