Nothing to fear but fear itself?

The yields on safe haven government bonds fell to a record low at the end of May. Nominal 2-year interest rates on Swiss and German sovereign debt are currently negative – people pay for the right to lend money to these governments. 10-year interest rates on bonds issued in these countries and in the US and UK are all below the expected rate of inflation over the next 10 years. Hence creditors expect to get back less in real terms than the amount they have lent their governments.

This is a symptom of extreme anxiety about the economic outlook. While dampened growth in Q1 in China, India and some other emerging markets, and generally somewhat lower activity indicators for the industrial sectors in both advanced and emerging economies, may go some way to explaining this pessimism, the main thing weighing on investors' minds is the outlook for the eurozone.

The upcoming parliamentary election in Greece has led a lot of investors to conclude that a Greek exit from the eurozone is a given. To some extent the market is also pricing in the likelihood of a complete breakdown of the eurozone, with all 17 member states reintroducing their own currencies. And that would be a calamity not just for Europe, but for the global economy as a whole.

Given that the stakes are so high, however, we think that only severe political mishandling would lead to a break-up of the eurozone. In fact, since the risk of contagion is real, we believe that Greece too will remain a member of the eurozone. Note that the electorate in Greece supports the euro by a huge majority. What Athens probably will demand, irrespective of who wins the June 17 election, is a renegotiation of the austerity package that the EU and the IMF has imposed on Greece. And we expect them to get it.

In the event of a "Grexit", we expect the ECB, the EU and the IMF to use all the ammunition they can muster in order to contain the crisis. If politicians hesitate, we expect the ECB to launch massive new rounds of long-term cheap financing of the European banking system. In addition we expect the ECB to de facto transform the monetary union into a fiscal union, by purchasing unlimited amounts of peripheral sovereign debt at certain guaranteed interest spreads relative to Germany. The ECB technocrats cannot do this without being given the green light by politicians. But we expect them to get the go-ahead, and for the politicians to then explain to their electorates and to try legally implement a fiscal union ex post.

The Economy at a Glance is a macroeconomic update by Torgeir Høien.

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