New market storm could catch euro zone unprepared
Distracted by an unresolved migration crisis and negotiations on keeping Britain in the European Union, euro zone leaders could be caught unprepared by a new storm on financial markets.
Global market turmoil since the start of the year has helped set warning lights flashing in euro zone sovereign bond markets. In early February, the premium that investors charge to hold Portuguese, Spanish and Italian government debt rather than German bonds hit some of the highest levels since the euro zone crisis that peaked in 2011-2012. European bank shares have been badly hit by concerns over their high stock of non-performing loans, new regulatory burdens and a squeeze on profits due to sub-zero official interest rates. New EU banking regulations that force shareholders and bondholders to take first losses if a bank needs rescuing are further spooking the market, notably in Italy.
All this comes at a time when public resistance to further austerity measures has surged all over southern Europe, producing unstable results at the ballot box.
Furthermore, the storm clouds are gathering above a tenuous and slow euro zone economic recovery - growth is officially forecast to reach 1.9 percent this year versus around 1.6 percent in 2015. Southern periphery countries all face budget problems that are fuelling political tension with Brussels.
Inflation is also refusing to perk up despite the European Central Bank's bondbuying program and negative interest rates, making it harder for heavily indebted euro zone countries to pay down debt.
Yet euro zone governments transfixed by differences over sharing out refugees, managing Europe's porous borders and accommodating British demands for concessions on EU membership terms have a huge amount on their hands already. One French government adviser said the EU had never faced such an accumulation of crises in the last 50 years.
At their most recent meeting, euro zone finance ministers said the latest market turmoil was no reason for concern at this stage.
They insisted that the euro zone is very different now from its situation in 2010 in terms of institutions and instruments available to handle another outbreak of the crisis.
Among them are the European Stability Mechanism (ESM) rescue fund, better capitalized banks, a partial banking union with a single supervisory authority under the ECB, a mechanism for winding down failing banks, and an embryonic bank resolution fund.
The ECB has also come a long way since 2010, widening its policy scope to so-called quantitative easing, creating money to buy euro zone government bonds in a bid to revive inflation and boost recovery.
Markets expect the ECB to loosen monetary policy still further next month, but it's not clear that such a move would bolster confi- dence in the banks.
And nothing that has happened so far is close to the problems seen in 2011-2012. The spread between Portuguese and German 10 year bond yields hit more than 1550 basis points then; the February 2016 high was just shy of 380 bps.
But worries about banks have been spreading to sovereign bonds in more vulnerable countries in a revival of the so-called "doom loop" that EU reforms were meant to remove. Pressure from euro zone hawks such as Germany and the Netherlands to either limit the amount of home-country debt that a bank may hold, or give national sovereign debt differential risk weightings on banks' books have added to uncertainty.