Buisness Insider

Why Investors Are Going Crazy For The Very European Government Bonds They Used To Hate

Italiangovernmentdebt

The above chart tells one of the most important stories in the world of economics. It shows the yield on Italian 10-year bonds.

Not long ago, Italy was one of a handful of so-called "PIIGS" countries, peripheral European countries that investors were avoiding like the plague. Others in this category included Greece, Ireland, Spain, and Portugal. And even France made investors nervous. These countries had (and continue to have) high levels of government debt, and generally mediocre economies overall. 

The fear was that the countries wouldn't be able to service their debt, and that they would possibly default and revert to their old currencies, leaving bond investors in the lurch.

But now look, Italian government bond yields are at their lowest levels in history. Not only has the trend reversed, the pendulum has swung far in the other direction. Investors are buying European government bonds like crazy.

What caused the turnaround? 

In the Summer of 2012, ECB chief Mario Draghi laid out a plan that would allow the ECB to backstop countries that got into fiscal trouble. Specifically, if a country was having problems in the bond market (borrowing money), then the ECB would agree to step in and buy an unlimited number of bonds (which the ECB has the ability to do, because it creates money), provided the country in question agreed to undergo further fiscal reforms.

The program Draghi spelled out was known as OMT.

As it turns out, Draghi never needed to use OMT. No country has actually had to call in the ECB for help.

But just the knowledge of the program's existence — that it can be used as an escape valve if necessary — was all it took to produce a ferocious rally in government bonds and a big drop in yields.

Today

These days there's even more reason to be bullish on European government debt.

Inflation is exceptionally low in Europe, particularly in peripheral countries.

Going back to Italy (which we're just using as an example) the rate of inflation is about as low as it was during the worst of the economic crisis.

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Falling inflation tends to create demand for fixed income assets, like government bonds.

Again, this story is being repeated all over the place in Europe.

Furthermore, there's a "shortage" of safe assets in the world. The Fed has bought up a lot of US debt (through QE) and we're not producing as much government guaranteed housing debt in the US like we used to. So a European government bond that has a theoretical guarantee from the ECB (if Italy ever gets into trouble) suddenly looks kind of appealing.

So what we're seeing across Europe are historic lows in peripheral government borrowing costs, as low inflation, a shortage of safe debt, and an ECB backstop conspire to make these assets look very attractive.

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