Europe’s Big Bet

March 10th’s Weekly Market Update

Bond yields have fallen this year, but they began to rebound in the United States in the latest week as the glass-half-empty bond market realized the all-time high stock market may have it right. But this was not the case in most of Europe. The ongoing decline in European government bond yields continued last week and is striking when considering how fast they were rising two years ago. What a difference a couple of years can make. The 10-year Italian and Spanish bond yields dropped to near all-time lows at the end of last week, while Greece’s 10-year — once over 35% — fell below 7%. Problem solved? Not exactly.

The countries once derided in the financial press for overspending PIIGS (Portugal, Italy, Ireland, Greece, and Spain) and thought deserving of their double-digit borrowing rates, could now be believed to be among the GAUDS (Germany, Austria, United Kingdom, Denmark, and Switzerland) and their low single-digit yields. As we have highlighted several times over the past two years, bond yields have receded as the risk of financial crisis has passed. But the situation in Europe is slowly transforming into an economic crisis in the form of a potential lengthy stagnation. We had anticipated Europe could shake off this risk and produce better growth this year — and it still may — but the risk of a setback rose last week.

The risk can best be seen in prices. Central bankers around the world, including the U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BOJ), have a clearly stated goal of 2% inflation, to motivate spending and lift wages while leaving a buffer above zero when growth inevitably slows again. While the inflation rates in the United States and Japan are just below that and rising, the pace of inflation in the Eurozone has been under 1% since October 2013 and is still decelerating.

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