When reflecting on current conditions in the bond markets it is worth remembering two aspects of their behavior. The first is that traders operate ruthlessly and quickly to changes in sentiment and expectations. And secondly, these changes may appear to be based on objective assessments of ‘the numbers’ but they embody many subjective views of the prospects for returns on debt. There is currently quite a divide between the negative mood in bond markets and increasingly positive news in the ‘real’ economy.
The consequence of the ruthlessness and speed of action of traders is that the markets have become an
unyielding and unforgiving pressure to force financial discipline: on companies as well as governments. In the presence of a single currency in the EU and having started down the road of fiscal deficit reforms, the EU has to now tough it out. The only way to convince the markets that sovereign debt is not at risk is to show that each country a) has a credible plan and b) that the plan can and will be implemented. So far, the markets believe a) but are continually re-adjusting their assessments on b) for a number of countries in the Euro.
unyielding and unforgiving pressure to force financial discipline: on companies as well as governments. In the presence of a single currency in the EU and having started down the road of fiscal deficit reforms, the EU has to now tough it out. The only way to convince the markets that sovereign debt is not at risk is to show that each country a) has a credible plan and b) that the plan can and will be implemented. So far, the markets believe a) but are continually re-adjusting their assessments on b) for a number of countries in the Euro.
As the pain of re-adjustment is felt in each EU economy so we can expect to see a growth of internecine fighting. The political futures of national leaders (of France, Germany and the UK in particular) is put under pressure if their electorates believe they are subsidizing indisciplned nations too easily while imposing austerity at home. Expect to see a lot more political posturing before the current crisis passes.
The US is just now moving in the same fiscal direction as the EU with the administration announcing a major move away from fiscal stimulus towards debt reduction. US debt will also come under the scrutiny of the markets in the coming months and may yet lose the confidence of bond holders in 2011.
But all is not negative and the markets may soon start to change their assessments of sovereign debt for there are increasing signs of the recovery gaining momentum. Remember traders rely on the perception of ‘the numbers’. The graphic below shows the progress of economic sentiment across the EU in recent times. The latest data – for November – shows a continued improvement above the baseline of 100.
And there have beene some notable improvements over the month for Germany (+2.8), the UK (+0.5) and the Netherlands (+0.4). The full report is available at the European Commission website. Germany has been showing significant growth with exports leading expansion which seems to be feeding through better corporate and consumer confidence overall. Likewise the UK has seen an unexpectedly good rise in exports in the last quarter. Surprising because it is something of a fashion to dismiss the UK as having any products to export that anybody wants to buy. But that ignores the many small and medium sized businesses in the country with high quality goods to sell – especially in the engineering and related sectors – where their imaginative and entrepreneurial leaders are optimizing market opportunities in high growth markets abroad.
Continued indications of growth in the EU will start to ease the markets’ concerns. Those concerns might also shift away from the euro if the US fiscal reduction plan starts to look at risk. And of course, any signs of difficulties in the Far East such as growing inflation in India or lower growth in China will shift the balance of risks away from the EU.
The next six months will be crucial. There are continuous risks in the system, ,but it is clear that the end of this period of major re-adjustment is in sight. The risks are increasingly located in the financial markets. We may start to see the positive news and progress in the ‘real’ begin to create more positive sentiment in the financial markets over the next two quarters.
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