Eurozone has two years to agree fiscal union, says DB Advisors

The viability of the Eurozone project continues to weigh on fixed income market, says chief investment officer of DB Advisors.

The Eurozone has a maximum of two years to agree fiscal union or investors will start to insist on higher bond yields, DB Advisors’ chief investment officer for Europe has warned.

Georg Schuh said it was up to the major Eurozone economies to make the deal quickly as this would be the primary focus of investors in the short term.

“We have to see what the outcome is of the €750 billion package [to underpin sovereign debt in the Eurozone] decided on the 9th and 10th of May,” said Schuh during a press conference call on June 17. “May was a bad month for risky assets and a good month for high grade sovereign bonds due to the fact that the stability of the Eurozone has been questioned again.

“Due to the package, politicians have 1.5 to 2 years to resolve the big issue, namely, that the Eurozone reaches some kind of fiscal union,” added Schuh, who is based in DB’s Frankfurt offices. “Strategically the question for fixed income investors, particularly in the Eurozone, will be to watch out whether the European countries, especially the big ones like Germany, France, Italy, Spain and the Netherlands, arrive at an agreement on some kind of fiscal union.”

Schuh believes markets have already priced a high probability of Eurozone break-up into the region’s sovereign bond yields, but warned further market volatility may be ahead if countries cannot press ahead with fiscal union quickly.

“The risks are high given that one to two years is a short time for politicians to sit round the table and agree to this. They face this risk that the voters won’t accept that the national parliament gives away their ability to decide on their national budget,” he said. “So this is the strategic issue: will there be a European budget or will the Eurozone continue with national budgets?”

As investor focus on Eurozone debt has increased in recent months, many economists have argued that monetary union should never have been attempted without fiscal union as part of the same package.

Moreover, the EU’s failure to achieve the objectives of the 2003 Growth and Stability Pact, which set ceilings on national debt and fiscal deficit levels for 16 EU countries, meant that national debt in Eurozone countries became a worry for investors in the wake of the global financial crisis and ensuing downturn. In recent months, this has resulted in spiking bond yields in more highly indebted Eurozone countries like Greece, Spain and Portugal.

“Some scepticism remains but on the other hand markets are already pricing in a high probability of a break-up of the Eurozone, so fixed income investors should look at the relative attractiveness or non-attractiveness of countries. We think that Spain is rather attractive compared to other core markets as we do think markets underestimate the significance of accumulated debt ratios. Spain is doing well [in this area],” says Schuh.

Eurozone members and the European Central Bank hope the establishment of the €750 billion bailout package and taking a tougher line on debt and deficit ceilings will be enough to restore confidence.

Yet many economists and investors see only fiscal union or Eurozone break-up as possible outcomes. Fear of the latter continues to weigh on the market.

“If the euro splits we’ll all lose, because there’s so much we share in economic terms,” says Raphael Gallardo, head of macroeconomic research at Axa Investment Managers in Paris. “Germany will lose and Greece will lose.”

“Separating the Eurozone would be like separating Siamese twins: it would be bloody. I hope we can find a political arrangement to avoid that. But to see the disintegration of the euro, we would need to see a greater degree of economic suffering and  greater political disintegration than we’re seeing now," adds Gallardo.