Bank of Italy Study Finds Euro Breakup Fear Behind Spread Surge
Wednesday, 05 September 2012 | 00:00
Sovereign bond yield divergence in the euro area doesn't reflect economic fundamentals of individual nations and appear largely to reflect fears the currency union will break up, the Bank of Italy said in a research report released Tuesday.
The study offers intellectual support to European Central Bank President Mario Draghi, who has said the central bank will intervene in markets to counter investor fears of the euro's demise.
An appropriate spread or interest-rate gap between Italian and German 10-year government bonds would be around two or two-and-a-half percentage points, according to the Bank of Italy researchers, who used a variety of indicators to reach their conclusion. Depending on the variable used, the spread should be as low as 120 basis points or as high as 370 basis points.
The current spread on Italian and German 10-year bonds is 424 basis points. A basis point is one-hundredth of a percentage point.
"Italy seems to be the most severely penalized country," Antonio Di Cesare and his four co-authors wrote in their Bank of Italy study.
They modeled what they described as appropriate yields based on public debt, fiscal and macroeconomic indicators as well as household wealth and determined that the relatively recent surge in euro-zone sovereign spreads "suggests that some common new risk factor is currently at play."
They identified that as "fears of the reversibility of the euro."
That risk factor also mathematically correlated to the yields of fiscally-strong sovereigns such as Germany, the authors said, describing the cost of debt in those countries as having undergone a "spectacular fall" in the past two years.
'Safe haven effects' may have pushed 10-year German bund yields down by as much as 130 basis points, according to the Bank of Italy research.
That means more than half the yield gap they found is due to fear of a euro breakup. In other words, eliminating that risk - as Mr Draghi has said he wishes to do - could push up German yields by 1.3 percentage point, meaning Italian yields might come down only 70 basis points.
The combination of the two would be tantamount to a 200-basis-point correction in the spread. In such a scenario, German 10-year bund yields would rise to 2.69% from their current level of 1.39%, while Italian yields would decline to 4.69% from 5.61%.
The Bank of Italy researchers acknowledge other factors may be at work, including concerns about a worsening fiscal outlook over the medium term of weaker euro area sovereigns and growing doubts about the risk involved in government debt in general.
Source: Dow Jones