Investopedia's Forex Outlook For May 2012: European Economy
Europe Goes From Crisis to Chronic
The eurozone has come a long way since the beginning of the region's sovereign debt crisis. Greece is no longer on the brink of destruction and the euro as a currency appears relatively stable with the help of some monetary easing in the form of LTROs. But while these operations helped improve sovereign debt yields, their expiration could spell trouble down the road.
Economic activity in the eurozone slowed more than expected during the fourth quarter of 2011, with output contracting in many member economies. The slowdown was primarily driven by a spike in perceived risk, from growth prospects, competitiveness and sovereign solvency in trouble peripheral countries, as well as Italy and Spain.
In 2010 and 2011, many economists speculated that the eurozone might actually collapse amid potential sovereign defaults and widening gaps between the north and south. Now, the mood has significantly improved after a large Greek debt write-off – resulting in an 80% loss for bondholders – and trillions of euros of liquidity thanks to the ECB's three-year LTROs.
The ECB's three-year LTROs provided cheap funding to European banks, which then reinvested the loans into sovereign debt issues. The result was sharply lower sovereign debt yields, particularly in troubled countries like Italy and Spain. And these lower yields helped improve financing for government spending by reducing long-term interest obligations.
Several Chronic Problems Remain
Despite the success of these liquidity operations, some economists remain cautious about the future of the eurozone. For instance, J.P. Morgan's Jamie Dimon noted on a conference call with analysts that it was a "short-term fix" rather than a "permanent fix." Indeed, sovereign debt yields are already starting to rise now that the "sugar high" has ended.
For instance, Spain's 10-year bond yields reached its highest levels since November of 2011, according to the Economist. Similar trends have been seen in Italy where yields have surpassed 5.5% in April of 2012. With these effects fading, it's becoming clear that the fundamental changes needed in many eurozone economies have not yet materialized.
Austerity measures put in place to cut spending have resulted in slower growth rates and put many eurozone countries into a vicious cycle. Meanwhile, countries like Spain face continued turmoil from a housing and mortgage bust, which has hurt its banks' balance sheets. The result has been higher yields that are approaching unsustainable highs.
Potential Solutions Are Elusive
Some economists are expecting policymakers to reinstitute purchases of sovereign bonds in the secondary markets to stem the rise. Others are watching for a fresh infusion of low-rate funding, similar to the LTROs, which could help encourage private banks to invest in sovereign debt. But ultimately, these solutions appear to many as shortsighted.
Many economists believe that troubled countries must implement a policy mix that supports the recovery, while addressing fiscal sustainability challenges and financial sector vulnerabilities. With the fiscal austerity in place, the support for growth falls largely on monetary policy. This could be done by lowering policy rates and continuing to use unconventional policies.
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