Can the Eurozone learn from the Latin American crisis 10 years ago?

Most of the comparisons in the media about the current European debt crisis have been based on the memories of the 2008 crisis following the collapse of Lehman Brothers. Perhaps the better parallel is that of the Latin American crisis more than 10 years ago.

So what were those lessons?

Before Eurozone members can think about returning to growth, they almost certainly require a huge involvement from the private sector and finance.

Firstly, the governments of the affected Eurozone members need to commit to primary surpluses (having a budget surplus before interest payments) and stop the drain on private sector resources. This position was determined by the International Monetary Fund around 15 years ago to stabilise debt in Latin America. Now, it is not surprising that these same countries are calling for the equivalent position for the Eurozone.

Secondly, the European Central Bank should stop buying sovereign bonds as that simply prolongs the primary cause of the crisis. Instead, it can provide “incentives” for the banking sector to renew lines of credit to the Eurozone while lowering the overall debt burden. This plan was a US-sponsored strategy that did emphasise some debt forgiveness through a debt-swap plan.

Finally, banks will require more capital to absorb the potential losses from this debt-swap, while accounting standards may need to be relaxed in the short-term to facilitate this. The fresh capital will need to be swift so as to not affect equity markets for too long. Banks will then need to sell-off non-banking assets and non-core assets to help with the recapitalisation.

While it will take some time to end this crisis (Latin America took five years to stabilise its economy), it can be achieved if policies encourage private sector to become involved. At present, markets are not seeing this and consequently economic growth in the region could continue to disappoint.

What is the Australian yield curve indicating?

Recent market events have changed the direction of the Reserve Bank of Australia’s (RBA) opinion on the direction of interest rates. Many analysts and economists look at the yield curve to provide guidance when forecasting the future direction of the economy.

Where are we in the cycle and what is the warning in the Australian yield curve?

While most investors take their cue from Wall Street on the direction of the market, there is a growing belief that the yield curves of countries and continents such as the United States, United Kingdom and Europe, are no longer “honest” due to the enormous intervention by central banks into the bond markets. The change in yield on the bond market creates the so-called “yield curve”. When the curve moves down, it means an expectation of an interest rate cut as a result of the weakening economic outlook or recession.

Why does an expected change in interest rates predict a recession?

This is the case as interest rates tend to move the economy and central banks utilise interest rates to slow down or reinvigorate economic activity.

The Australian yield curve is one of the few remaining “un-manipulated” curves. We believe it may be more reliable in forecasting the economic outlook. Currently, the yield curve is pointing downwards for the next two years before rising again. This indicates that investors are expecting a recession sometime over the next two years.  Further, we feel that if other nations had not manipulated their yield curve, they would also point downwards. Consequently, could the warning in the yield curve be right?