The market-implied probability of default declined in all euro area countries in January and, with the exception of Greece, remains significantly below 10%. On average, markets now assess the probability of default at less than 5%, significantly below the peak of 35% seen during the heights of the crisis. While still elevated, the estimated probability of default fell by 5.1 percentage points in Greece amid the news that Standard and Poor’s upgraded the sovereign’s credit rating from B– to B.
The market’s improved perception of euro area sovereign debt is set against the backdrop of a strong cyclical upturn in 2017, with the euro area economy growing by 2.5% last year — the fastest rate since 2007. Stronger growth and a declining unemployment rate should boost government tax receipts and improve sovereigns’ fiscal positions.
The surge in economic growth has also reduced the degree of economic slack with the European Commission’s quarterly survey of industrial firms reporting capacity utilisation at 84.4% — close to its all-time high of 85.1%. A similar survey for the services sector estimated capacity utilisation at 90.2%.
With this in mind, Fathom expects the ECB’s quantitative easing programme to conclude in September. As Fathom has previously highlighted to clients, it is likely that this tightening in the monetary policy stance will prove to be a litmus test for peripheral sovereigns and could see spreads rise.
For all countries, the market-implied probability of exiting the currency union is below 10%, in part reflecting greater optimism surrounding the currency union’s future. In particular, two key events — the election of President Macron in France and the probable formation of a grand coalition in Germany — could pave the way for significant reform to the European Stability Mechanism and the completion of banking union. These two crucial reforms would greatly enhance the currency bloc’s long-term sustainability and could potentially be the first tentative steps towards Fathom’s ‘golden scenario’ where the euro area becomes a fully fledged economic and monetary union.
There are, however, potential headwinds on the horizon. The most notable of these is the Italian election, currently scheduled for March of this year. While some of the policies proposed by Italian politicians could prove detrimental to the country’s growth outlook, Fathom views it to be unlikely that many of these will come into fruition.
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