After a new year in the financial markets dominated by sinking share and oil prices, could even worse be on the way?
“By far the most worrying recent development… is the ominous signs of a return of the eurozone’s sovereign debt crisis,” writes Jonathan Loynes, chief European economist at Capital Economics.
He notes that both Greek and Portuguese government bond yields have spiked recently, as the following chart from the consultancy shows. “The need for further bold policy action from the European Central Bank has become even more pressing,” Loynes writes.
Loynes reckons the last week or so has felt like a potentially important turning point for the eurozone as the market focus, previously on the global economy in general and China in particular, has moved closer to home.
Eurozone economic growth, he argues, is likely to slow, while “the downside risks to eurozone growth have clearly been exacerbated by the recent turmoil in global financial markets and the associated potential effects on wealth and confidence.”
Banking worries, Loynes writes, have been worsened by expectations of how the European Central Bank will respond to the deteriorating economic outlook. “In particular, further cuts in the ECB’s deposit rate – as are widely expected – could have adverse effects on eurozone banks’ profitability if they are unable to cut their own deposit rates or raise their lending rates to compensate,” he adds.
More worryingly still, so-called “peripheral” government bond yields had initially remained low amidst the downturn in global equity markets. But that has changed markedly over recent days as both Portuguese and Greek yields have spiked higher, Loynes notes.
He argues that the debt crisis is not over and could be reignited by, among other things, another downturn in the global economy. There is little evidence that markets are panicking about an imminent Portuguese default. “Nonetheless, the combination of a weak global environment, fiscal worries in Portugal and a still contracting economy in Greece is an alarming one,” Loynes writes.
“Particularly worrying is the potential return of the so-called ‘doom loop’ between banks and sovereigns, wherein weaknesses in the banking sector have adverse effects on government’s fiscal positions, prompting falls in the value of sovereign bonds held by banks, and so on.”
Overall, Loynes writes, “it is perhaps a bit early to conclude that a new phase of the eurozone debt crisis has now begun. For now at least, the adverse market movements are smaller and more contained than in previous bouts.
“Nonetheless, the growing signs that the global market turmoil is starting to infiltrate the currency union have made the already pressing case for additional policy support even more urgent. We continue to anticipate both a further cut in the ECB’s deposit rate – of perhaps 20 basis points – and a significant increase in the pace of its monthly asset purchases at the next policy meeting in March.”
On Monday, European Central Bank President Mario Draghi told the European Parliament’s Economic and Monetary Affairs Committee that the ECB is ready to ease monetary policy next month if the recent financial market turmoil or the long-term impact of low energy prices threaten to keep inflation persistently low.
According to Reuters, the markets are now pricing in at least two rate cuts, taking the deposit rate to minus 0.50% by the end of the year from minus 0.3%. But analysts are more cautious, expecting just one rate cut to minus 0.4%.