Bonds - The Vanishing Risk Premium

Watching yields on sovereign debt these days is like a fantasy world, reality no longer exists.  While the debt is real, the yields are totally unrealistic.  This is particularly the case for the former Eurozone debt transgressors, Portugal, Ireland, Italy, Greece and Spain.

Here is a chart showing the debt levels in euros (except the United Kingdom) as supplied by Eurostat for the advanced European Member States for the end of 2013 and 2010 and the percent change in the nominal debt, debt-to-GDP levels for 2013 and 2010 and the percentage point change in debt-to-GDP levels from 2010 to 2013:

Let's look at a graph showing the change in actual debt levels in euros from 2010 (in red) to 2013 (in blue):

All nations except Greece saw their debt grow between 2010 and 2013.  Among the PIIGS nations, Portugal saw its debt grow by 31 percent, Ireland saw its debt grow by 41 percent, Italy saw its debt grow by a rather meagre 12 percent, Greece saw its debt shrink by 3 percent (thanks to massive intervention) and Spain saw its debt rise by a lofty 49 percent.

Here's a graph showing the percentage point change in the debt-to-GDP levels from 2010 to 2013:

Notice that the debt-to-GDP level for all advanced European nations grew with the exception of Germany.  In the cases of Greece, Ireland, Portugal and Spain, four of the main debt transgressors, debt-to-GDP ratios grew by between 26.8 and 35 percentage points over the three year period!

Now that we have that in mind, let's look at the current yield on ten year bonds for the PIIGS nations, starting with Portugal:

The yield on ten year Portuguese bonds is 3.81 percent, up from its 2014 low of 3.2 percent in June but well down from its high of 15.1 percent in January 2012.

Here's the yield on ten year bonds for Italy:

The yield for ten year Italian bonds is 2.88 percent, down from 7.1 percent in November 2011.

Here is the yield on ten year bonds for Ireland:

The yield on ten year Irish bonds is 2.299 percent, down from 14 percent in June 2011.

Here is the yield on ten year bonds for Greece:

The yield for ten year Greek bonds is 6.25 percent, down from 36 percent in early 2012.

Here is a chart showing the yield on ten year bonds for Spain:

The yield for ten year Spanish bonds is 2.77 percent, down from 7.6 percent in mid-2012.

Now that we've looked the bond yields for the less solvent Eurozone Members, here is the yield for Germany:

The yield on 10 year bunds is currently 1.21 percent, down from a peak of just under 3.5 percent in July 2011.

Let's summarize.  In general, German bunds are considered the benchmark Eurozone bond.  The risk premium to the 10 year bund has dropped to:

2.6 percent for Portugal

1.67 percent for Italy

1.089 percent for Ireland

5.04 percent for Greece

1.56 percent for Spain

Compared to the current yield of 2.55 percent on ten year United States Treasuries, the risk premium has dropped to:

1.26 percent for Portugal

0.33 percent for Italy

-0.25 percent for Ireland

3.7 percent for Greece

0.22 percent for Spain.

Given that the nominal debt and debt-to-GDP levels for all of the PIIGS nations, save Greece, have risen substantially over the past three years, it is quite clear that the risk premium associated with the bonds of Portugal, Italy, Ireland and Spain are terribly out of line with the investment risk involved.  While I'm not terribly comfortable with the debt level of either Germany or the United States, the debt of these two nations is the yardstick used to measure debt worthiness.  It's clear that in their haste to increase the yield or their investments, bond investors have exposed themselves to risks that they may otherwise not have been willing to take, particularly given the fact that Europe's debt crisis is obviously on a temporary hiatus.

The Eurozone's Shrinking Economic Growth Predictions

With the debt issues facing a rather large handful of the Eurozone Member States hitting page one of many of the world's mainstream media newspapers, I thought that I'd take a look at the most recent economic forecast for Europe provided by the European Commission.  Their Interim Forecast for September 2011 suggests that all is not well in the Eurozone as far as projected economic growth is concerned for the second half of 2011.

The EC projects that economic growth is expected to come to a standstill in the second half of this year but is not expected to result in a double dip recession.  For the entire year, GDP growth is forecast to be 1.7 percent with third and fourth quarter growth falling to 0.2 percent, revised downward by 0.2 and 0.3 percentage points for the aforementioned quarters.  Here is a graph showing the quarter-over-quarter growth since 2007:

Notice that quarter-on-quarter growth for 2011 is well under the growth levels experienced in the Eurozone prior to the Great Contraction.  After quarter-over-quarter growth rates reached 0.8 percent in Q1 2011, it fell to a paltry 0.2 percent in Q2 2011 with a pronounced drop in exports which were down from 2.2 percent quarter-over-quarter growth in Q1 to 0.6 percent in Q2 because of weakening global trade.

Here is a graph showing the negative change in growth levels for several EU member states from the first half of 2011 to the second half of 2011:

Notice how widely the economic growth rates vary across the EU.  Notice as well that Italy is projected to have near zero growth for the second half of 2011, well below the EU average.  This should be of great concern since Italy has the world's third largest nominal sovereign debt and is being pressured to adopt austerity measures in order to prevent default.

Tension within the banking system is rising.  The three month LIBOR (London Interbank Offered Rate) OIS (Overnight Index Swap) has risen by 75 basis points and is at its highest level since the spring of 2009 when the merde really hit the fan.  Overnight deposits with the European Central Bank have risen to over 150 billion euros in early September, indicating that banks are not lending to each other.  This indicates that there is mistrust within the banking system similar to what was seen during the Great Recession.  This is NOT a good sign.

On the upside, the EC expects that consumer price inflation should drop very modestly over the second half of 2011 as energy prices moderate somewhat as shown in this graph:

In contrast, the United Kingdom is expected to have higher inflation that originally projected since increased energy prices are due in the second half of 2011.

Unemployment is expected to remain stable at about 9.5 percent in the EU and 10 percent in the euro area, only slightly lower than last year.  Once again, changes to unemployment levels are anticipated to vary widely across the EU with Germany showing the most improvement and Spain showing the least.  Employment prospects are not expected to improve over the second half of the year.  Here is a graph showing the changing unemployment levels for the EU, euro area and a smattering of Member States:

Let's take a brief look at the prognostications for two of the EU Member States that reside at opposite ends of the fiscal spectrum.

Germany experienced rapid quarterly growth in Q1 2011, with real GDP growth of 1.3 percent on a quarterly basis.  This dropped to 0.1 percent in Q2 2011, partially due to the impact of shuttering nuclear power plants.  Over the full year, German real GDP growth is expected to reach 2.9 percent.  Moderation in growth is expected for the second half of the year and consumer sentiment has dropped because of increasing uncertainty over Eurozone debt levels.

Italy noted very modest real GDP growth of only 0.1 percent in Q1 2011 followed by real growth of 0.3 percent in Q2.  Real GDP growth for the second half of 2011 is expected to be flat with year-over-year growth of only 0.7 percent, a downward revision of 0.3 percentage points.  Recent issues in the country's bond markets will increase costs for corporations looking to finance expansions and will likely affect their investment decisions.  Consumer sentiment has fallen markedly over the past few months as well, affecting private consumption levels.

When I look at prognostications involving economic growth, I always keep in mind that GDP growth numbers, in particular, are lagging indicators that are subject to frequent revisions.  In this past quarter, growth rates in many EU Member States, Canada and the United States have been surprisingly low, far below what economists predicted earlier this year.  My uninformed guess is that the growth numbers for the second quarter of 2011 will be revised downward and that we are most likely experiencing an economic contraction, if not now, by the second half of 2011.  This could well make the sovereign debt issues facing nations like the PIIGS members reach the critical point.

I find it most interesting to see the economic diversion among the founding nations within the EU umbrella.  Perhaps it really was a state experiment destined to failure.  Only time will tell and I suspect that we'll find out sooner rather than later whether the EU will remain a world economic force.

Youth Unemployment in the Eurozone - Will it lead to further unrest?

With all of the youth-inspired unrest in the United Kingdom over the past few days, I thought that it would be interesting to look at the social issues facing young people in the U.K., particularly their employment prospects and compare their issues to those facing the youth of other EU and extra-EU nations.  

In the second quarter of 2011, youth unemployment in the United Kingdom fell to 19.7 percent with 917,000 unemployed 16 to 24 year olds.  This is a drop of 0.7 percentage points from the previous quarter when there were 959,000 unemployed youth, the highest since record-keeping began in 1992.  The statistics also showed that there were 75,000 youth that had not held a job for two years, an increase of 43 percent from a year earlier.  As we saw in the case of Egypt, perhaps at least some of the actions of young Brits over the past few days is related to a sense of hopelessness rather than just being completely attributable to hooliganism.

Here is a look at some interesting youth employment statistics compared to national unemployment statistics for several countries around the world:

United Kingdom 16 to 24 years of age: 19.7 percent compared to 7.7 percent nationally.

France 15 to 24 years of age: 22.8 percent compared to 9.7 percent nationally.

Greece 15 to 24 year olds: 43.1 percent compared to 15.8 percent nationally.

Canada 15 to 24 year olds: 14.1 percent compared to 7.2 percent nationally.

United States 16 to 19 year olds: 25.0 percent compared to 9.1 percent nationally.

Here is a graph comparing the total unemployment rate for the EU-27, the EU, Japan and the United States:

Here is a graph showing the rise in youth unemployment across the Eurozone over the past decade:

Here is a chart showing the actual statistics for the year 2009 showing how much higher unemployment for those EU citizens under the age of 25 is when compared to unemployment for those between the ages of 25 and 74 years:

The youth unemployment rate in the EU-27 has been two to three times the rate for the total population over the last 10 years.  That cannot help but lead to trouble over the long term as a sense of hopelessness overtakes the optimism of one's early teen years.

Perhaps, in some way, this explains (but does not excuse) the anger on the streets of the United Kingdom just as it did in Egypt earlier this spring.  The social contrast between those who are elected to run the governments of Europe and North America and European and North American young adults is profound.  In recent history, the divide between our society's "ruling class" and the have nots has rarely been wider and deeper.  Anger towards the system is sometimes directed toward unexpected targets and it is that anger that appears to be contagious.

In light of the likely implementation of widespread government austerity programs as a "Hail Mary" approach to balancing decades of fiscal mismanagement, it will be interesting to see where mob anger strikes next.