The Euro-zone Crisis Moves Back to the Front Burner

Long time readers of my Updates will remember that last year I was writing about how our ultra-low mortgage rates were partly a by-product of rising investor fears of a euro-zone collapse.

The Bank of Canada (BoC) was loath to raise its overnight rate in the face of so much global uncertainty and our Government of Canada (GoC) bonds were in high demand as capital fled into a shrinking pool of safe-haven sovereign debt. Canadian fixed- and variable-rate borrowers alike were taken along for the ultra-low rate ride. But then European Central Bank (ECB) President Mario Draghi stared down Spanish and Italian bond-market vigilantes with his promise to “do whatever it takes” to save the euro zone and the crisis retreated from the headlines and appeared to calm from a boil to a simmer.

While I haven’t written about the euro-zone crisis for a while, it is still far from over. In fact, thanks to the latest bailout plan for Cyprus, it is back on the front pages today. 

The problem that has been building in the euro zone for some time is that the German-led austerity initiatives that were supposed to put imperiled euro-zone countries back on the path to fiscal solvency haven’t worked. So far at least, government spending cuts and sharply higher taxes have stifled economic growth and have caused revenues to fall faster than expenditures.

As these already gaping government deficits widen and reduction targets are missed, the response from the German-led Troika, comprising the European Commission (EC), the International Monetary Fund (IMF) and the ECB), has been to impose still more austerity. Meanwhile, the response from voters in the euro zone’s imperiled peripheral countries has been to throw increasing support behind nationalistic leaders who run on anti-austerity platforms. I think it will be this growing friction that fuels the next wave of the euro-zone crisis.

The real lynchpin in each euro-zone bailout is German Chancellor Angela Merkel, who has used the austerity programs imposed by the Troika as her political cover for risking Germany’s strong national balance sheet to keep the euro zone from imploding. But there has been a growing disconnect between Chancellor Merkel’s tough talk on austerity and the actual policies being implemented on the already austerity-scorched economic earth in the bailed out euro-zone countries. This is a disconnect that her political opponents will highlight in the lead-up to German federal election on September 22, 2013, and I think it partly explains why the just announced Cyprus bailout proposal is attempting to forge new and dangerous ground (more on that in a minute).

The euro-zone leadership would like nothing better than a quiet summer leading up to the German election. Nothing would upset the fragile euro-zone experiment more dramatically than diminished German support for this pan-European experiment. The challenge is that while the experts I read still believe Germany will be asked to do much more (such as debt metallization, or even outright debt forgiveness) before the current crisis ultimately abates, sharing this candid assessment with German voters isn’t a recipe for electoral success.

The timing of euro-zone developments over the next six months is critical. If a new crisis forces austerity-weary voters in the imperiled euro-zone countries to come face-to-face with bailout-weary German voters, this could push the whole experiment to its breaking point. (In fact, I believe the message contained in the Cyprus bailout proposal is sowing the seeds of the next crisis as I write this.)

To that end, here are several recent euro-zone developments that bear watching:

• Cyprus received a bailout offer over the weekend and for the first time, savers who had deposits in Cypriot banks with supposedly insured balances will lose 6.75% of their money as part of the bailout. Until then, deposits have been staunchly protected throughout the euro-zone crisis. Now that depositors have been tapped in the euro-zone’s latest crisis, depositors all over the euro zone will be nervous, in some countries very nervous. There is now much more risk of bank runs and of large, destabilising transfers of money out of the weaker banks and countries.
• Italy has the third largest bond market in the world and last week Fitch, a major rating agency, downgraded Italy’s sovereign bond rating to BBB+ and kept its outlook as ‘negative’ (meaning Fitch sees future negative momentum for Italian bonds). Italian ten-year bond yields closed last week at a manageable 4.60%. But just suppose Italy’s politicians fail to form a government and another election is called, this time with more anti-austerity and anti-euro-zone rhetoric? Given that bond yields surged .30% during the last vote, how much will they surge this time? If the ECB needs to start buying Italian bonds en masse, what austerity can the Troika impose with both Italian and German elections in the offing?
• On a more general level, euro-zone GDP is expected to contract by 0.3% in 2013, unemployment rates are soaring (Greece – 27%, Spain – 26%, Portugal – 18%, France – 11%), and the emergency Long-term Refinancing Operation (LTRO) loans that were made by the ECB have not been repaid at anything like the expected rate. Really, the current state of the euro zone means that the next crisis could come from just about anywhere.

Government of Canada (GoC) five-year bond yields fell by one basis point over the past week, closing at 1.37% on Friday. Five-year fixed-rates are widely available in the sub-3% range as lenders continue to vie for spring-market business. With such aggressive rate competition, borrowers have the luxury of focusing on each lender’s terms and conditions – and these can make a surprisingly big difference to your borrowing costs over time (the link in the last sentence gives you one glaring example).

Five-year variable-rate mortgages are still being offered in the prime minus 0.40% range (which works out to 2.60% using today’s prime rate). The BoC has just changed its Mortgage Qualifying Rate (MQR), which is used to qualify all variable-rate applications. The MQR was lowered from 5.24% to 5.14%, thus making it a little easier for borrowers who are interested in variable-rate financing to qualify.

The Bottom Line: If the threat of sovereign default in the euro zone rises again, I think investors will once again seek safety in GoC bonds. This would put downward pressure on our GoC bond yields and by association, our fixed-mortgage rates. But if the euro zone breaks up and sovereign defaults actually occur, bond market investors may then demand a higher return for all sovereign debt, which would push our bond yields (and fixed-mortgage rates) higher. That’s why I will remain an ‘interested’ observer as the euro-zone crisis returns to a boil in the coming months.