If we had to flag up a particular anomaly in the financial markets, that undoubtedly would be the low return offered by some long-term sovereign bonds, especially the German. In general, the trend in the IRR of very long-term sovereign bonds has been on the decrease in the last two decades. In the ten years between the birth of the euro and the financial bubble’s burst, the IRR on the 30-year sovereign bond in the Eurozone countries fell from levels of 6% to 4%, without much of a difference between countries. Spain, France and Germany paid a very similar interest rate, consistent with a very similar credit quality. In this same period, the IRR offered by the US bond for the same period was quite similar to that of the eurozone countries’ bonds; just marginally higher in nominal terms, reflecting a reality and expectations for a slightly higher inflation rate.
With the outbreak of the financial crisis, the equilibrium between the IRR of the sovereign bonds was blown out of the water. The IRR of the Spanish 30-year bond climbed to over 7%, while that of the German bond fell to 2%. The IRR on the French and US bonds was at similar levels of between 3% and 4%. It was suddenly as if Spain was being considered as insolvent and, while the risk perception for France and the US remained similar, Germany looked like the safest haven. Apparently much more solvent that the US, the leading global economic power.
But had the risk of Spain defaulting really increased? And, above all, had the difference between the US and Germany’s solvency widened so much? It wasn’t quite like that. Neither Spain, France, Germany nor the US had ever stopped taking care of their public debt payments since the second World War. What is true is that, up until the birth of the euro, Spain took care of it with pesetas, France with francs, Germany with marks and the US with dollars. And what the market was afraid of was that this situation could return. So the interest rate did not reflect a radical change in the perception of the insolvency risk, but rather no less a probability, which the market was discounting, that, although they were solvent, each country was solvent in their own currency, due to a breakup of the euro. If there was a breakup of the euro, it was on the cards that the peseta would devalue, the mark would revalue and, judging by the market’s behaviour, there would be no significant change in the franc or the dollar’s exchange rate.
The risk premium was not so much about a differential in the yield due to lower credit quality, but about expectations for devaluation. In 2013, Draghi pronounced his categorical phrase “whatever it takes”, the ECB began to buy public debt and a return to normality started. The Spanish 30-year bond, which at the worst point of the crisis paid out 5% more than the German bund, today trades with a differential of 1.6%. In absolute terms, it offers the same return expected from the US 30-year bond.
The fact the German bund (as well as the French bond) continue to offer significant yield differentials compared with the US bond, shows us we have not yet returned to complete normality
But, since Macron’s elections as the President of France, the doubts over the irreversibility of the euro are dissipating. As a matter of fact, in the last three months, the yield differential between the US bond and the German 30-year bonds has fallen by 40 basis points, from 2% to 1.6%. The market itself is discounting that the long-term inflation differentials of the Eurozone and the US should not vary by more than half a percentage point. If this is the case, it’s foreseeable that in a few quarters that differential will decline to a level of around half a percentage point where it historically was, before the financial crisis. In this case, the most plausible scenario would be to wait until the drop in the differential happened due to a recovery in the IRR of the German bund, which would offer a long-term investor the possibility of a minimum expectation for a real return.
The logic behind there being homogeneous long-term interest rates amongst countries with similar credit quality does not just have to do with the fact that, in the past, that was how it was. Think about an Arabian, Russian or Chinese investor who doesn’t have either the dollar or the euro as his own currency. But he wants to invest in the least risky asset for the longest time frame possible. That investor has two very clear options: buy a US bond or a German 30-year bond. At current rates, the return he will accumulate at maturity buying a US bond is spectacularly higher than he will obtain buying a German bond; as much as results from capitalising the first one at 2.85% annually and the second at 1.25%. The result would only be the same if at the end of the investment period the euro had revalued a lot against the dollar; if what had been gained because of the interest rate, buying bonds in dollars, was lost in the exchange rate when the principal was returned.
In the following table, you can see what the exchange rate, expressed in dollars/euro, should be in 2047 (the maturity date of a 30-year bond bought today) which would equal the return for an investor on US bonds or Eurozone bonds.
If he invested in a German bond (German euro), he will only gain the same as investing in a US bond if the euro revalues to 1,82 dollars/euro. If he were to invest in the Spanish bond (Spanish euro) the return obtained would be the same (today both bonds pay almost the same interest, 2,85% in the case of the US bond and 2.83% for the Spanish bond), if the current exchange rate of 1,14 dollars/euro was maintained.