What's behind recent European market movements

The euro has fallen back to the pre-rescue package lows. Why? (And it's not because the rescue package failed to restore confidence.)

By , Guest blogger

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    Reviewing the five contributing factors of interest rates can explain the recent drop in the euro.
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After rallying initially on Monday, the euro has fallen back to the pre-rescue package lows. Does this mean, as Paul Krugman suggested, that the rescue package failed to restore confidence?

No, as usual Krugman is wrong.

If the problem really had been that fear of defaults persists, then bond yields in troubled countries would have risen at the same time. But as it happens, they have not only not given up the initial drops, they have continued to drop.

But why then has the euro dropped in value?

To answer that question we need to remind ourselves of what factors influence interest rates:

In short, it is:

1) Time preferences of households, companies and governments.
2) Inflation premium
3) Liquidity premium
4) Perceived risk of default
5) Central bank demand.

There is no reason to assume that factor 3) has changed, so that can be ignored in the continued analysis.

Factor 4) is a factor which certainly has changed (the perceived risk has gone down), and which has contributed to strengthening the euro and reducing bond yields in the crisis hit countries. The reduced decline in the perceived risk of default is mainly a direct effect of the rescue package, but also in part a result of the inflationary effect of a weaker euro, which will increase nominal GDP and ease the relative debt burden.

Factor 5) is a factor which also has changed since the ECB by changed its asset portfolio from consisting entirely of loans to banks to partially consisting of loans to government (bond purchases in other words). This will have the effect of reducing bond yields, while it has little effect on the euro's exchange rate.

Factor 1) has also changed and also contributes to lower yields in the entire euro area. By lowering interest rates it also likely lowers then value of the euro. The reason why it lower yields is that because of the austerity measures announced, government demand for loanable funds will drop.

Given the rally in gold, with the euro price of gold approaching €1,000 per ounce for the first time ever, factor 2), it seems likely that markets distrust the ECB's pledge to "sterilize" their government bond purchases, and therefore expect higher inflation, something which other things being equal will weaken the euro and raise nominal bond yields in the entire euro area.

Applying this theoretical analysis to the specific phenonenoms, factor 4) contributes to a stronger euro, but this is counteracted by the weakening effects of factors 1) and 2). Empirically in this case, factors 1) and 2) appears to be slightly stronger than the effects of factor 4).

For German bond yields, factors 1) and 5) contribute to lower yields, but factor 2) increases them. As German bond yields have been roughly unchanged, the effects of factors 1) and 5) appears to be roughly equal to the effects of factor 2)

For yields of bonds issued by Greece, Italy, Spain and Portugal, factors 1, 4 and 5) contributes to lower yields while factor 2) increases them. As these bond yields have dropped dramatically, it appears as if the combined effects of factors 1, 4) and 5) are a lot bigger than the effects of factor 2).

In summarize, inflation fears seems to have increased, while fears of default and net government supply of debt securities have dropped. The net effect of this implies continuing weakness in the euro, unchanged German bond yields and lower bond yields in Greece and other Southern European countries.

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