Macro: The Bottom Line (7/14/2014)

Ghosts from the Eurozone debt crisis

 

The Eurozone debt crisis has been dead for months - or so the markets have been behaving for much of this year. Few securities have illustrated this better than Portuguese government bonds. At the start of 2014, the Portuguese government was paying 6 pct to borrow for 10 years. By mid-June, that cost of borrowing had fallen below 3.5 pct! You certainly would've been forgiven for believing that the days of runaway deficits and hundred billion-euro bailouts were forever banished to the history books.

 

That was until Portugal's second-largest bank brought the old ghosts back last week. Espirito Santo International - the parent holding company of Banco Espirito Santo - delayed interest payments on some of its short-term debt obligations. The panic effect was immediate. Stock markets on both sides of the Atlantic tumbled. Portugal's 10-year bond yields shot back up toward the 4 pct market, those of Spain and Italy rose as well, while U.S. Treasury yields dropped. Greece managed to raise only half of its initial estimate of new funds in its newest bond issue. After months of complacency, markets were no suddenly bracing for a return to the horror days of 2011.  

 

But how much do we actually need to worry? Will a not-too-well-known Portuguese bank unleash the next wave of instability in the Euro area? We think not.

 

First, the payment delay at Espirito Santo was more a result of company-specific problems, rather than of broader macro issues. Sure, the operating environment in the peripheral European economies has been anything but rosy, but ultimately it was the labyrinthine, opaque operating structure of the Espirito Santo conglomerate that brought it to its knees.

Second, in terms of systemic relevance and interconnectedness with the European financial system as a whole, Banco Espirito Santo pales in comparison to banks in Northern Europe or the U.K. In other words, it definitely isn't "too big to fail."

Third, in the unlikely case that the turbulence does get out of hand, the ECB has explicitly committed itself as a last guarantor of financial stability in the region. If anything, a pickup in market stress will only prolong the ultra-loose central-bank policy that we've discussed so extensively by now. Over the medium term, that should keep asset prices well-supported.

We're certainly not arguing that the Eurozone debt crisis is over. The list of structural issues - lack of competitiveness, rigid labor markets, an overbearing public sector - has barely been touched. Incidents such as the Espirito Santo episode will surface every now and then. But - not the least given the hyperactivity of central banks - the risk of full-blown market meltdown is not where it used to be.