Morning Memo: Why are borrowing costs rising for eurozone governments?

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The ECB says it’s closely monitoring what’s going on in government debt markets.

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OVER THE LAST week or so, eurozone (including Irish) government bond prices have fallen to their lowest levels in about six months.

Bonds — effectively IOUs from governments to investors — are the main mechanism through which governments raise debt to fund spending.

They have a price, which can shift over time as the bonds are sold on secondary markets and a maturity date: a deadline for repayment.

Bonds also have something called a ‘yield’, which (to oversimplify it massively) reflects the annual return to the investor if they decide to hold the bond to maturity. Yields and bond prices are inversely related so as one goes up, the other goes down.

Now, compared to, say, investing in stocks or commodities, bonds are considered a relatively safe and steady investment because the investor receives periodic interest payments and the principal is returned after the maturation date. The market for bonds is also very deep, meaning investors have a lot of opportunities to sell their investment on short notice.

In a nutshell, high demand for bonds (ie higher prices and lower yields) mean lower borrowing costs for the government that issued the security.

Last year, in the initial wave of Covid panic that spread across financial markets, demand for the safety of bonds pushed yields and borrowing costs down to near-record lows. But very quickly, as the rapid spread of the virus created more panic, investors became desperate for cash and in early March 2020, a huge sell-off in government bonds pushed prices down and yields/borrowing costs up.

This was a major problem for eurozone governments like Italy and Spain — which already had high historic debt levels — at a time when they needed to borrow quickly to fund their pandemic response.

The solution came from the European Central Bank, which launched a bond-buying programme called the Pandemic Emergency Purchase Fund. Over the past year, through the €1.85 trillion initiative, the ECB has bought huge tranches of European government bonds, creating a baseline of demand for that debt and keeping borrowing costs for governments very low. Over the past week, however, bond prices have begun to slip again.

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Again to oversimplify it, investors are getting very confident that the vaccines are going to allow economies to reopen in the short to medium term. Because of that, they’re taking their money out of safe bets like bonds and putting it back into shares in companies that might benefit from reopening. Effectively, there’s been a bond sell-off, which means lower bond prices, rising yields and higher borrowing costs for governments.

In response and in order to keep government borrowing costs down, the ECB will probably have to increase the pace of bond-buying. Another problem is that there’s only €1 trillion left in the tank and the programme is due to run until at least March 2022 or when the crisis has abated, whichever comes first.

So could another extension of the programme or an increase in its size be on the cards in the near-term? We’ll have to wait and see.

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