What Will Increased Stability in Europe Mean For Interest Rates?

Over the past few weeks several notable turning points have been reached by European authorities striving desperately to stave off the fiscal insolvency of a number of eurozone member countries. On September 12^th, Germany’s Constitutional Court confirmed that the German government could ratify the eurozone’s new, permanent bailout fund, the European Stability Mechanism (ESM). While there were several caveats most notably that the lower house of the German parliament, the Bundestag, had the right to veto any increase in future payments into the ESM, this decision on the part of the court was momentous. Germany is Europe’s largest and most powerful economy and was the only eurozone member who had not yet ratified the ESM. With ratification now declared constitutional, Germany signed the treaty bringing the ESM into existence, thus creating a permanent bailout fund that could be used by the European Central Bank (ECB) to begin purchases of the sovereign debt of eurozone countries. By stepping in as a buyer of last resort, the ECB will be providing a backstop to the European sovereign debt market that should help countries like Spain and Greece that are struggling to contain soaring borrowing costs which are unsustainable even in the short term without such a relief mechanism in place.[1]

Although many politicians and finance officials hailed this dramatic turn of events, one long delayed by intransigent domestic opposition within Germany to the participation in such a fund, especially given that at 27% Germany would be the ESM’s primary contributor, others voiced a note of caution. Gunnar Beck, an EU analyst at London's School of Oriental and African Studies, was gloomy about the long-term effects of the decision, "In the short term the market will be booming, but in the long term this means unending horror. Germany is locked in now and it means that if the ECB buys unlimited bonds, Germany's liability is unlimited as well," he said. "Germany is like a bank that has lent too much to its biggest client so that it has to continue lending until the client goes bust".[2] Others seemed to share his concern as several weeks after the German court’s decision, a group of finance ministers from Germany, Holland and Finland indicated that the plan to move bad bank assets off the books of struggling eurozone governments would not apply to what they termed as “legacy assets”, which is a oblique reference to funds borrowed by some national governments that was then used to bailout their domestic banks. The funds in the ESM, the group of finance ministers declared, would only be used for such direct recapitalization efforts going forward and would not be employed retroactively to pay off existent debt. This leaves governments like Spain and Greece responsible for past loans, which backtracks from a deal struck earlier in the summer.[3]

Still, political maneuverings aside, a long term solution to the European financial crisis is slowly beginning to crystallize. Qualified goods news from Spain followed the German ratification of the ESM as a stress test of that country’s banks revealed, that in a worst case scenario, there would occur a smaller shortfall in funds than had been initially feared, with approximations centering around $75 billion. That the Spanish financial system is in terrible shape and in need of a massive capital injection is indisputable, but this lower figure, combined with the construction of a budget that contains $51 billion in austerity cuts necessary to allow Spain to formally request a bailout, adds further optimism. By completing the stress tests and structuring their budget per the EU Commission’s and ECB’s requirements, the last hurdle to Spain being the beneficiary of the ESM’s proposed bond buying program has been cleared. This will do much to lower Spain’s borrowing costs, and calm fears that other, even larger economies, such as Italy’s, would be left without recourse if they too require financial assistance.[4] Additionally, there is hope it will serve as a salve to increasingly violent protests within Spain, protests that have become so contentious that one entire province of Spain, Catalonia, has threatened to secede from that country, even going so far as to contact the EU authorities as to the legality of such a move and the associated roadmap that would be needed for membership in the EU as an independent state.[5]

Progress is being made, but much remains to be done and the situation is, at times, tumultuous. Europe will require several more years, at a minimum, to restructure the way eurozone member countries borrow money to fund themselves and for the hoped for positive effects of that restructuring to take effect. Investors despise uncertainty, and with Europe’s fiscal situation likely to remain in flux for the foreseeable future, bond buyers will continue to seek the safe haven provided by the United States Treasury market. This inflow of capital will only amplify the effects of the Federal Reserve’s most recent quantitative easing efforts thus further ensuring that interest rates will remain at or near the historic levels they have occupied for the past several years. This is great news for borrowers, who will benefit from the lower cost of money, but investment vehicles, like pension funds, whose charters require they focus on low risk investments, such as Treasuries, will continue to see disappointing returns.