Philip Coggan: Change in eurozone sentiment is key

US economic data have continued to suggest that America is in for a year of decent growth and even Europe has shown a few signs of life.

But perhaps the key development has been a change in sentiment about the eurozone debt crisis. That might seem surprising given the downgrades announced by rating agency Standard & Poor’s in January. However, those downgrades were much anticipated by the market and bond yields had moved accordingly.

What has really counted is not the opinion of a rating agency but the weight of investor demand. Spain set the ball rolling on January 12 by selling €10bn (£8.4bn) worth of bonds, twice its original target. Yields on Spanish bonds maturing in two years dropped to 2.8 per cent, from a peak of 6.1 per cent in November. Italy sold one-year bonds at a yield of 2.7 per cent, after having to offer 5.9 per cent at the previous auction.

Lower yields are a big help because a debt crisis can become a vicious circle. When investors are nervous about a country’s ability to service its debt demand higher yields, those higher yields make it more difficult to service the country’s debt.

But what is driving this improvement? The most likely answer is that the European Central Bank has, in effect, turned to quantitative easing via the back door. Just before Christmas, the ECB agreed to lend banks €489bn over three years. There were plenty of hints from politicians that the banks could reinvest this cheap money in European government bonds and many may well have done so. The effect is very similar to the quantitative easing programmes of the Federal Reserve and the Bank of England, under which the central banks have bought government bonds directly.

A second round of ECB three-year financing will be on offer in February and Dhaval Joshi of BCA Research reckons the available amount could be as much as €1trn. Again, that would unleash an enormous volume of buying power into the European government bond market.

If, as you read this, you get an uneasy feeling, you’re not alone. This whole crisis started with the banks which had to be rescued by the governments. Now the ECB is lending money to the banks, which are struggling to find finance in the money markets, so they can buy the debt of governments, which are struggling to attract international investors.

The whole thing looks rather like the apocryphal tale of the man who hauled himself up by his own bootstraps. Another analogy might be the business empire of Robert Maxwell, in which group businesses traded assets with each other and all seemed to have cross-holdings. In the end, Maxwell was raiding money from his pension funds to keep his businesses afloat. But governments are not above such devices either: private pension fund assets have been “reabsorbed” by the current Hungarian administration and by the Argentine government in 2008.