Tuesday, January 24, 2012

Are EMU-Bonds currently mispriced? (ls)

Paul deGrauwe makes this case in his article on voxeu. He argues that government bond markets in a monetary union may be subject to self-fulfilling liquidity crises and hence to multiple equilibria. He claims that the sharp widening of the periphery's spreads should be mainly attributed to adverse changes of the market sentiment. The following picture serves him as an argument:

He writes that:

It presents pooled time-series and cross-section observations of the relation between the spreads of ten-year government bond rates of Eurozone governments compared with the German bond rate between 2000 and 2011 (quarterly observations). The red line represents the regression line indicating that increasing spreads are associated with increasing debt-to-GDP ratios. This line could be called the ‘fundamental relation’ between spreads and debt ratios.

How can this regression line be a fundamental one when it is mainly derived from observations in the pre-crisis period? Valuations in the pre-crisis period weren't fundamental at all. He makes this point himself. And I would like to add that we shouldn't exclusively blame the market. Favorable collateral and captial requirements posed by the ECB and by the respective banking supervision authorities played their role as well. But back to the chart: Large deviations of periphery spreads from the fitted regression line are taken as a sign of irrationality. This seems inconsistent to me, as the fitted line itself cannot serve as a fundamental benchmark. Drastically rising spreads do not imply a deviation from fundamentals, but rather a deviation from the optimistic pre-crisis consensus how to (under)price sovereign risk. In the end, we cannot distinguish whether we witness an adequate repricing or pure exaggeration.