The euro area has come a long way in the past five years. Back in 2012, financial markets were rattled by the prospect of sovereign default and government bond yields rose significantly as a result. Now the crisis years are behind us and leaders are in discussions about how to further enhance the currency bloc’s stability. Nevertheless, talk of a break-up is never too far from the press headlines.
Fathom’s proprietary indicators, which estimate the unconditional market-implied probabilities of sovereign defaults occurring within the next five years, also peaked around 2012. Fortunately, neither Italy nor Spain defaulted, and the currency bloc has not only survived the crisis but is currently riding high on a broad-based cyclical upswing. Consequently, the unconditional probabilities of default indicators remain low (below 10%) for all countries bar Greece.
Even so, many European economies are still hamstrung by elevated debt levels, a constant cause of concern for countries such as Italy. Fathom would therefore caution that, in some cases, the market is underestimating the likelihood of default.
Furthermore, Fathom would caution that the probability of one country defaulting in isolation is incredibly low and that a default by one country may trigger a default in another, especially given the cross-border exposures of the euro area economies. To assess such possibilities, Fathom calculates conditional probabilities of default which show the probability of one country defaulting given the prior default of another, e.g. what would be the probability of Spain defaulting on its debt within the next five years if Italy already had? As was outlined in a recent note to clients, these conditional probabilities were incredibly high during the peak of the crisis.
Of course, default was not the only risk during the heyday of the crisis — euro exit was also a pressing cause for concern. And questions over membership of the currency union have reared their heads once more, given the strong performance of the Eurosceptic Northern League and the Euro-cautious Five Star Movement in the recent Italian election.
Fathom also calculates the market-implied likelihoods of countries quitting the single currency. In all countries (including Greece), the unconditional probability of an exit occurring within the next five years remains less than 5%. And, even if Italy declared its intention to return to the lira, the market currently does not expect other countries to follow suit.
Overall Fathom concurs with the market’s view that the euro area is unlikely to fall apart in the near future. Arguably, there is even some scope for upside risk if Germany and France make progress towards enhancing the durability of the currency bloc’s structural framework — a so-called ‘golden scenario’ for the euro area.
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