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Markets awash with liquidity can both conceal and exacerbate underlying economic problems and long-term solvency issues. Investors and policy makers in the eurozone ought to have learnt that lesson from the pre-crisis bubble years. Instead they have both swung from blind panic to short-sighted complacency within less than two years.

But the crisis in the eurozone is far from over and markets are pinning too much hope on the European Central Bank embarking imminently on quantitative easing.

Sovereign yields in the struggling “periphery” have plunged ever since ECB President Mario Draghi pledged to do “whatever it takes” to save the euro in July 2012.

But while the initial fall in yields from their panicky heights was welcome and justified, the epic rally this year is taking them into bubble territory.

Yes, prospects have improved since a year ago. Southern European economies are no longer reliant on external funding and are finally growing again. But in their hunt for yield, investors are ignoring the risks that remain.

The banking crisis is unresolved. Public debt is still rising. And the recovery remains feeble.

Indeed, with inflation sharply down and prices falling in some parts, nominal GDP growth has scarcely improved. It was minus 1.4 per cent in Ireland and 0.1 per cent in Italy in the year to the fourth quarter of 2013, and 0.3 per cent in Spain in the year to the first quarter of 2014. In effect, the eurozone is relying entirely on achieving and maintaining large primary surpluses for decades to stabilise and bring down debts – a tall order.

At the very least, then, debt dynamics in the “periphery” are precarious. And precisely because the fear of imminent doom has abated, politics in countries with scarily high unemployment and crushing debts could easily become more turbulent.

Yet even with a stagnant, unreformed economy, unstable politics and public debt of 133 per cent of GDP, Italy can now borrow for 10 years at a little over 3 per cent, a euro-era low. So can Spain, for the first time since the bubble era in 2005.

In Ireland, 10-year yields have plunged to a mere 2.89 per cent, only 20 basis points above US Treasuries. Yet the economy tanked in the fourth quarter of last year, it has debts of more than 150 per cent of GNP (adjusted for profits booked there for tax purposes), and it emerged from its EU-International Monetary Fund programme only last December.

Junk-rated Portuguese 10-year bonds yield less than the 4 per cent offered by triple-A rated Australian ones.

Even an insolvent Greece, which restructured its privately held debt only two years ago, owes a mountain more to the EU and the IMF and is still reliant on their funding, recently tapped markets for five years at a mere 4.95 per cent. Since Greece’s public debt – 172 per cent of GDP and rising – remains unsustainably large, investors are in effect gambling that the government will prioritise repaying them and eurozone authorities will be willing to grant Greece some form of debt relief.

Or you could lend to triple-A rated New Zealand for five years and get 4.2 per cent.

Sentiment can turn quickly. Witness the whiplash emerging markets suffered when the US Federal Reserve announced its quantitative easing taper last year, and again when the taper began. While the prospect of tighter US monetary policy may eventually weaken the euro against the dollar, it also presages higher global interest rates, a big negative for the debt-laden eurozone.

So what? The ECB is about to launch its own QE programme and inflate bond prices. Not so fast. So far, all the ECB has done is try to talk the euro down. Any further loosening is more likely to take the form of a negative deposit rate than QE. Remember that Germans are happy with their inflation at 0.9 per cent. They, and many others at the ECB, tend to see falling prices in southern Europe not as a problem but part of the necessary adjustment process.

Frankfurt will also be reluctant to embark on another experimental policy so soon after the German Constitutional Court ruled its Outright Monetary Transactions illegal. With the ECB still engaged in its asset-quality review of eurozone banks, QE also seems premature and of dubious benefit. And the more markets rally in anticipation of QE, the more likely the ECB is to delay, in the hope that the bond-market bubble will spill over into stronger economic growth.

While the sun shines, governments should rush to pre-fund their borrowing needs. But investors ought to be warier of the looming storm clouds – as should eurozone policy makers, who have yet again prematurely declared victory.

Posted 29 Apr 2014 in euro, Finance, Financial Times, Published articles

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