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Bond Yield Spreads in the European Financial Market

Question:

Discuss About The Contagion During Greek Sovereign Debt Crisis?

The European sovereign debt crisis had a great impact on markets and several implications. The impacts of the debt crisis were so deep to the world's economy that we can still observe them today especially at the Eurozone's countries such as Greece, Spain, Italy, Ireland and Portugal (Lane, 2012). High volatility of the euro markets has been a significant factor during the crisis period. Those high levels of volatility can lead to high interest rates of borrowing for the countries with debts and as a consequence to high bond yield spreads.

 Several European countries at the same time faced collapse in their financial institutions and government debt. This led to rising spread amongst bond yield spreads in government securities from the year 2008 which started in Iceland with its banking system collapse and spread to Greece, Ireland and Portugal (Von Hagen, 2011).

Fig. 1. Bond yield spreads for EU-15 central governments, January 1991-May 2009.

As we can see in figure 2 the bond yield spreads for the EU-15 central governments during May 1991 till October 2006 were low, whereas the bond yield spreads during October 2006 and May 2009 were extremely high. Investors seeing higher associated risks with bond investing needed higher return for compensation of such risks. There was a vicious cycle present that led to surge in demand for higher yield bonds leading to higher borrowing costs for all country’s that were experiencing crisis situation. Fiscal strain operating within the country especially in Greece led to demands for higher yields and subsequently investors losing their confidence affecting selling. European Union acted gradually by opting for bailouts of nations especially troubled economies. In totality the European Union along with International Monetary Fund disbursed a total of 110 billion euros to Greece alone. Then Portugal and Ireland opted for bailouts, following establishment of EFSF providing emergency lending to countries in difficulty. The Long Term Refinancing Operation (LTRO) established programs for bailouts for countries. Various countries held on to their reserves for their economic growth and boost their bank balances. Several endeavours were made by European policy makers for stabilising their financial markets, to save their fiscal health. With ECB coming into action investors became bully globally reinvesting again in bond markets of smaller nations.


Government bonds are historically considered as the safest investment. After the crisis, investors starting to lose their confidence in the stock market and as a result they stop investing on it. Consequently, investors turned to government bonds and this led to a rise in the demand of bonds (Aizenman, 2013). Therefore, Central Banks tried to increase their holding of government bonds. Because of the increased demand, the price of the bonds has been raised.

Government Bonds as Safe Investment

European countries believed collapse or Euro along with financial contagion by the International Monetary Fund (IMF). Several countries in the European Union including Greece received bailout funds for preventing crisis within their economy for slowing down of public sector debt. Demand for governmental bonds or sovereign paper rising which eventually led to their inability to pay (Arghyrou, 2012). These banks resorted to third party financial institutions as European Central Bank (ECB), European Financial Stability Facility  (EFSF) and International Monetary Fund (IMF) for their payments. There were a total of 17 countries belonging to the European Union that voted for creation of EFSF for resolving European debt crisis.

Source, Bloomberg : Euro Index from 2001-2012


The above graph shows the historical price graph of the European government bonds 7-10 years of maturity. The graph shows that the price of the government bonds gone very high from 2001 till 2012 and it is still rising. Inability to repay government financed debt led to refinancing of such instruments (Mink, 2013). The primary drivers of European Sovereign Crisis was financial crisis which was a direct consequence of Greet Recession in 2008 – 2012, which eventually was related to real estate market property bubbles. Greece government had gross underestimated its budget deficits which led to financial crisis and rising rates of the bond market. 

Source, Bloomberg : Bond Indices for US government 7-10 year, Bloomberg Finance L.P.

The above graph shows the US 7-10 years of maturity price of the government bonds from 2001 till 2012. Again, because of the correlation of the European economy and the US economy the sovereign debt crisis has led the bond prices to high levels. What is more, if we observe the graph we can clearly notice that during 2008 and 2012 there is high volatility which indicates the high demand for government bonds during that period. The US economy due to persistent demand in debts had to raise their rates for fiscal position (Beirne, 2013). European countries were also made unsustainable due to rising levels of unsustainability.

The stock market is different to the bond market. During credit instability the price of the shares of the firms will decrease. Furthermore, when economies enter into recession the expected profit of the firms is going to be lower thus the firms are going to pay less dividend. Therefore, investors will lose their interest in the equity market and they will eventually turn to other markets such as bond markets. The following graphs drawn from Bloomberg are showing the price levels for S&P 500, EURO STOXX and NIKKEI 225 for the period of 2000 till 2012. As we observe there is high volatility to all three equity markets. Furthermore, the low and high prices of the Euro equity index and the Japanese equity index are quite high whereas the prices of the US equity index are low. During January of 2008 the prices fall down for the EURO STOXX and the NIKKEI 225 and the S&P 500 experienced great loses during November of 2008. The S&P 500's prices went up on March of 2009 whereas the EURO STOXX's and the NIKKEI's 225 prices remained low.

Stock Market during the Crisis Period


Though initially there was a substantial pool of investors in the equity market, but with rising debt levels investors started diverting their funds. There was high inflow of funds that took place in the debt market, with investors booking profits in the equity market. Diverted funds from the stock market of Europe led to crisis in the equity market as well (Arezki, 2011). Low liquidity led to tremendous pressures on companies to dividends, who felt constrained now to be able to pay off debts. With collapse of governmental debt, there was pressure building in the equity market, where panic selling rose to a substantial extent. Debt crisis reignited panic across all markets, especially in equity and also in commodity markets. With countries opting for bailout situations, there was a wave of panic that frightened Spain and Italy. Double-dip recession with opposition to tax increase and cuts in welfare funds, panic swept across entire stretches of European nations. Spain and Italy being centred around hostilities in their bond market fears, made it a suitable target for nervous traders. Investors were interested in safe avenues as Gold and US dollars from all over Britain, Germany and US.   

Source, Bloomberg : EURO STOXX INDEX from 31/10/2000 - 29/10/2012

Source, Bloomberg : S&P 500 INDEX from 31/10/2000 - 29/10/2012

Source, Bloomberg : NIKKEI 225 from 31/10/2000 - 29/10/2012

During the sovereign debt crisis the world's economy collapsed. There were many implications in all type of markets such as the derivatives, commodities, foreign exchange market and of course implications in the gold prices and the oil prices. After the housing bubble, the commodity market entered its own bubble. From 2007 till summer of 2008 oil prices went very high and then plunged to very low price by the end of 2008. Oil though was not the only commodity to experience swings in the prices. Table 1 illustrates the declines for some of the commodities during 2008 compared to the declines during 1970 - 2007.

Swing in oil prices led to oil companies losing millions of dollars in the market as well as in their businesses. Oil price was highly destabilised during recession leading to low levels of profit margins (Beetsma, 2013). Other commodity prices also experienced tremendous swing that led to fluctuations in commodity market as well. Implications of Euro Sovereign Debt crisis led to downturn in all aspect of the European economy. There was a sharp decline in demands across Euro zone countries through all relevant channels of international trade. Crude oil prices have become extremely volatile in the international markets. World economy and financial market trends have said to influence influential crude oil price drivers. European bank stocks along with European markets as a whole performed worse at the time of crisis, which led nations to underperform. Political influence arising from crisis situation was immense that pushed nations towards austerity or cutting gaps in revenues and outlays. There were mixed thoughts that led to European nations often evaluating abandoning Euro. This would impact regional policy and countries would have more freedom to include individual independent policies. There were 17 nations in totality that depended on same currency and common policy. With abandoning of the same there would be an impact of large magnitude on global economy and its financial markets.   

Commodity Market and Oil Prices


Deepening debt in the European markets led to downward trends in crude oil markets. With Greece re-opting for bailout, investors view on crude price remained bearish. There had been several fundamental challenges along with failure of the banking system that led to Greece asking for repeated loans. With tandem in world economy and financial markets, oil supply and demand situations have also been affected. The fundamentally upward crude prices have been lagging behind providing future course for the world economy. Currently bond markets have gone to lower levels which has driven prices and brought down prices of bonds. Greater investor risks in bond market, slows down economic growth of countries leading to deflation. While ECB continues its efforts by slashing of interest rates, it aims to further include a quantitative easing program that had earlier been used in U.S. Federal Reserve.  

Table 1. The commodity bubble, Source: World Economic Outlook Crisis and Recovery

The commodity market outlook along with bond and equity markets remained bearish, with rising attention to geopolitical tensions. European debt crisis is a multi-year debt crisis which initiated in 2009. Various scholars attribute consolation of currency union without fiscal union being primary cause of the crisis. The crisis deepened as several banks in Europe owned a significant amount of bonds which negatively reinforced banking systems. Though there were several financial measures that were implemented to resolve crisis situation, bailout of Greece was fundamental to resolving such situations. Ireland and Portugal was able to significantly return from bailout situation and managing their crisis. There was adverse effect on labour market and unemployment rates as well on these European countries. Political impacts on these countries were also immense that influenced various outcomes for several elections.  

Reference Lists

Aizenman, J. H. 2013. What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk. Journal of International Money and Finance, 37-59.

Arezki, R. C. 2011. Sovereign rating news and financial markets spillovers: Evidence from the European debt crisis.

Arghyrou, M. G. 2012. The EMU sovereign-debt crisis: Fundamentals, expectations and contagion. . Journal of International Financial Markets, Institutions and Money, 658-677.

Beetsma, R. G. 2013. Spread the news: The impact of news on the European sovereign bond markets during the crisis. Journal of International Money and Finance, 83-101.

Beirne, J. &. 2013. The pricing of sovereign risk and contagion during the European sovereign debt crisis. Journal of International Money and Finance, 60-82.

Lane, P. R. 2012. The European sovereign debt crisis. The Journal of Economic Perspectives, 49-67.

Mink, M. &. 2013. Contagion during the Greek sovereign debt crisis. Journal of International Money and Finance, 102-113.

Von Hagen, J. S. 2011. Government bond risk premiums in the EU revisited: The impact of the financial crisis. European Journal of Political Economy, 36-

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