A Deutsche Bank Research report published on Monday says a look back to the early 1990s shows that sovereign bond spreads versus German benchmark Bunds have remained below historic peaks for most economies. In particular, spreads of the Southern European economies (e.g. Italy, Spain, Greece and Portugal) are still far below their pre-Eurozone levels. On the other hand, spreads of Austria - - heavily exposed to Eastern Europe economies - - and Ireland - - in the aftermath of a sever property crash  - - recently exceeded or at least came very close to historic peaks. It asks what are the reasons behind these developments?

The current yield on an Irish 10year bond is 5.38% compared with the bund rate of 3.38%.

The European Central Bank benchmark rate is 1%.

The DBR report, Eurozone sovereign spread widening - Reasonable market reaction or exaggeration?, says first, one should bear in mind that sovereign spreads do not only reflect default risks but are also driven by other risk factors such as market liquidity or investor preferences. Moreover, before the introduction of the euro as a single currency more than a decade ago sovereign spreads were also largely driven by exchange rate fluctuations and by inflation differentials towards low-inflation Germany, especially in the case of the Southern European countries with their comparatively high consumer price inflation rates. Southern European sovereign spreads were also capturing the increased risks of surprise inflation and/or currency devaluation in these countries, as these factors potentially threatened the value of sovereign bond holdings.

DBR economist Sebastian Becker says since September 2008 various risks factors have overshadowed Eurozone sovereign bond markets. Some risk factors are country specific (as e.g. a deep housing market recession in the case of Spain and Ireland, or the banking sector exposure to Eastern Europe in Austria).

However, other risk factors are of a more general (i.e. structural and hence Eurozone-wide) nature, e.g. the growing external imbalances between Eurozone member states. These structural imbalances have been reflected, on the one hand, by large current account surpluses of some member states (e.g. Finland, the Netherlands and Germany) and matched, on the other hand, by large current account deficits of some other countries (e.g. Greece, Portugal, Spain and Ireland). These external imbalances have primarily been the result of the past years’ structural divergence in Eurozone labour markets. Countries like Germany have kept nominal wage increases in line with productivity gains, thereby ensuring stable or only marginally higher unit labour costs (ULC). By contrast, ULCs in Greece, Italy, Ireland and Spain have risen significantly since the start of Eurozone as nominal wages have persistently outpaced labour productivity gains.

Hence, some Eurozone countries like Germany have gained international cost competitiveness despite a stronger euro whereas Southern European countries and Ireland have steadily suffered from declining competitiveness.

Becker says these developments can largely be summarised in one single number: the real effective (i.e. trade-weighted) exchange rate (REER) of a country. While the REER has appreciated sharply over the past few years for Southern Europe and Ireland (confirming the decline in these countries’ international competitiveness), it has significantly depreciated for Germany. Even though the REER is subject to relative unit labour cost developments and also partially driven by nominal exchange rate movements versus non-Eurozone trading-partner currencies, the main feature of the growing external imbalances within Eurozone is obvious: sizeable current account surpluses for the low-ULC countries and growing deficits for the high-ULC economies.

Becker says so far Ireland has to pay upfront fiscal outlays of almost 40% of GDP in financial sector support, according to Fitch Ratings. This includes an estimate of future losses on toxic property loans. Moreover, the Irish government faces contingent liabilities of almost 190% of GDP, partly explaining why Irish sovereign CDS spreads are currently so wide.

The current order between the Eurozone countries’ spread levels seems to be roughly in line with economic fundamentals. The countries with high public debt-to-GDP ratios, large current account deficits and declining international cost competitiveness are the ones with the widest sovereign bond and CDS (credit default swaps) spreads.

Sebastian Becker says a return to pre-crisis levels is not likely to happen soon.