In mid-2012, yields on 10-year Italian and Spanish government bonds were more than 4 percentage points higher than yields on 10-year German and U.S. government bonds. Since then, spreads have narrowed to the point where the yields on Italian and Spanish bonds nearly match those on U.S. securities. Christopher Neely, an assistant vice president and economist with the Federal Reserve Bank of St. Louis, examined whether this means the default risk for Spanish and Italian bonds is comparable to that for U.S. bonds in a recent Economic Synopses essay.
The reason for the spreads two years ago was the perceived risk of default by the Italian and Spanish governments on their debt, given their fiscal problems. This risk became a concern for the existence of the euro and a matter of great concern for the European Central Bank (ECB). In July 2012, ECB President Mario Draghi stated, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Following this statement, spreads narrowed significantly between Spanish/Italian bonds and U.S. Treasuries, and also between Spanish/Italian bonds and German bonds, though not as significantly, as spreads were still at about 1.5 percentage points as of late June. Neely noted, “Although the differences in euro area yields … are almost entirely due to default risk, the yields on U.S. Treasuries are not, in fact, directly comparable to those on Spanish or Italian government bonds. Why not? The difference lies in the fact that U.S. Treasuries pay in dollars and Spanish and Italian government bonds pay in euros.”
Neely explained that investors have to consider all risk factors, including the expected return on the exchange rate. He said, “Exchange rate changes are essentially unpredictable over any short period, but there is reason to believe the changes reflect bilateral differences in inflation rates over long periods, such as 10 years.”
The year-over-year euro area consumer price index was 0.5 percent versus 2.1 percent for the U.S. in May 2014, and inflation swaps1 predict 2.6 percent inflation in the U.S. versus 1.7 percent inflation in the euro area over the next 10 years. Neely said, “Lower inflation in the euro area suggests the euro might be expected to appreciate 0.9 percent annually against the dollar, mostly offsetting the 1.3-percentage-point difference in yields between U.S. Treasuries and German [bonds].”
Neely concluded, “In summary, Italian and Spanish government bonds still have a non-negligible risk premium compared with either lower-risk German [bonds] that also pay in euros or U.S. Treasuries after accounting for the expected changes in the exchange rate.”
1 Inflation swaps are derivatives that provide market-based measures of expected inflation.