Why a euro safe asset won’t rival U.S. Treasuries anytime soon

Capital Economics is skeptical about the near-term establishment of a new, unified euro 'safe asset,' citing the market's current fragmentation and significantly smaller scale compared to U.S. Treasuries, alongside an overestimation of potential benefits. The firm highlights a persistent lack of political consensus, with core countries resisting risk-sharing and skepticism surrounding non-risk-sharing financial engineering proposals. While the supply of existing highly-rated euro bonds is projected to increase, Capital Economics warns this may not result in cheaper funding due to factors like ECB quantitative tightening and potentially deteriorating German fiscal dynamics, which could widen spreads and impact other 'safe' countries' credit status.

Analysis

A unified euro 'safe asset' is unlikely to materialize in the near term due to significant structural and political hurdles, according to a Capital Economics report. The existing market for safe euro assets, valued at just over $9 trillion or 50% of the region's GDP, is substantially smaller and more fragmented than the U.S. Treasury market, which exceeds $30 trillion or 108% of U.S. GDP. Political consensus remains elusive, with core countries resisting risk-sharing proposals like joint EU borrowing, while non-risk-sharing options involving securitization are met with skepticism. The report contends that the perceived benefits, such as lower borrowing costs, are overstated, noting that Germany's 10-year yields are only about 15 basis points lower than the Netherlands' despite its bond market being €2 trillion larger. Furthermore, any significant drop in borrowing costs could be offset by the ECB tightening policy. While the supply of existing AA- or higher rated euro bonds is projected to grow from €7 trillion to €9.5 trillion by 2030, this may not reduce funding costs. Instead, risks are mounting for widening spreads, evidenced by past increases during ECB tightening and German political instability, a trend that could be exacerbated by forecasts of larger German deficits. This poses a contagion risk, potentially raising yields for other 'safe' sovereigns and threatening the top-tier credit status of countries like France if debt dynamics deteriorate.

Key Decisions for Investors

• Given the forecast for wider German Bund spreads and fiscal risks, investors should consider the relative value of U.S. Treasuries over European sovereign bonds, as the U.S. market remains the preeminent unified safe asset.
• Holders of long-duration European sovereign debt should closely monitor fiscal developments in core countries, particularly Germany's deficit and France's debt trajectory, as deterioration could lead to higher yields and capital losses.
• The structural inability to create a rival to U.S. Treasuries reinforces the dollar's reserve currency dominance, suggesting a potential long-term headwind for the EUR/USD exchange rate that should be factored into currency positioning.
• Monitor for any signs that the ECB may tighten policy to counteract fiscal loosening, as this could lead to unexpected upward pressure on regional bond yields.