Would a Common EU Bond Give U.S. a Run for Its Money?

The European Union on Wednesday unveiled a historic proposal to fund fiscal stimulus through a common bond issuance. This would be a bond backed not by any given country, but effectively by the bloc as a whole. I don't normally write about European bonds in this space, as I doubt even our European readers are actively trading bonds with negative yields. But if the Eurozone can put aside political differences and issue a group-wide bond, that will have far-reaching implications for global markets. Before getting into how this proposal might impact markets, we should note that there are considerable political hurdles. Already the Netherlands has expressed reservations, and enacting this program will require a unanimous vote. That said, France and Germany already back the proposal, and therefore I'd expect some version of a Euro-wide bond program is coming. Safe Asset Shortage As the U.S. ramped up its deficit spending during the Covid-19 crisis, we heard considerable consternation around how the market would absorb all these Treasury bonds. In reality, though, there is a shortage of safe assets in the world. Now the term safe can have a lot of meanings, but here are some important elements that would make up the ideal safe global asset. These include: Large issue sizes, allowing very large investors (like big foreign currency reserve buyers) to own a meaningful amount Issued a widely traded currency Sold in a variety of maturities, facilitating easy hedging and/or liability matching Regular new issues, allowing for consistent price discovery Heavily traded and highly liquid, both through repo-like transactions and normal trades Right now, only Treasury bonds meet all those criteria. German bond issuance isn't that large owing to their fiscal austerity. Japanese bonds don't trade that actively, since most of the buyers don't sell. U.K. gilts come closer, but the market is smaller and sterling is a much less traded currency than the dollar. A large-scale EU-wide bond program would solve all those problems. Already the EU has said it intends on issuing in a variety of maturities. I'm sure investment banks would be happy to repo these bonds. The euro is a widely used currency, and is naturally used by many of the most important safe asset buyers in the world, from global insurance companies to foreign reserve buyers. Competition for the U.S.? If this program actually gets off the ground, the EU bond will become meaningful competition for U.S. Treasuries. Hence all else being equal, U.S. interest rates should rise by some small degree. But in the short-term, the need for U.S. dollars specifically will keep Treasury bonds as the dominant safe asset. If, over time, central EU bond issuance becomes the dominant form of public finance in the Eurozone, then it would probably elevate EUR as a viable challenger to USD dominance. The depth and liquidity of the Treasury market is among the key reasons for USD's hegemony around the world. That would take a long time and likely a continued evolution of political attitudes in Europe. But it is something to watch as this program develops. Funding Fiscal Stimulus for Europe The whole reason for proposing a Euro-wide bond issue now is to fund an ambitious fiscal stimulus package. The plans include spending for green projects, transition toward a more digital economy, and something called the Solvency Support Instrument, which would allow countries to bailout national champions hit hard by the Covid crisis. It isn't exactly the fiscal package I would have designed, but Europe could sure use a demand boost. So I'd say compared to the alternative, this is definitely positive. One element of the common bond possibility that might fly under the radar is how it will benefit banks. Right now, European banks are often the primary buyers of their local country's debt. If this common bond flourishes, it will make those banks much less dependent on the fiscal health of their home country. Furthermore it would likely eventually allow for cross-border consolidation, since it would no longer be problematic for Italy that an Italian bank is bought by a Spanish bank. Making Monetary Policy More Powerful Perhaps most importantly, fiscal expansion has the potential to make monetary policy also more powerful. Increased fiscal spending is obviously a direct increase in aggregate demand. But it should also make equilibrium interest rates somewhat higher. In the case of Europe, interest rates are already at zero or even below. Since the central banks can't effectively lower rates any further, incremental monetary stimulus is less powerful. However if the fiscal expansion also increases equilibrium interest rates, that could give monetary policy room to operate. On balance, this is very positive for European growth both short-term and long-term. I will definitely be watching how the proposal progresses as the various members engage in negotiations.

Would a Common EU Bond Give U.S. a Run for Its Money?

The European Union has unveiled a historic proposal to fund fiscal stimulus through a common bond issuance, and it could mean real competition for the U.S. Treasuries.

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