The turnaround has been underpinned by government-provided downside protection of financial institutions’ balance sheets, which has reduced tail risk, improving macroeconomic news and better than expected earnings, especially by financial institutions. Against this background, the equity markets have rebounded, led by financial stocks. At the same time, historically low levels of money market interest rates have induced a hunt for yield among investors, triggering outflows from bank deposits and money market funds into riskier assets, including corporate bonds issued by lower-rated borrowers. Euro area bond and equity markets Over the past six months, euro area long-term bond yields have declined. However, in late November 2009, the slope of the euro area yield curve remained steeper than at any point in time since the launch of the euro, due to the past declines in short-term market rates (See Chart 8). Intra-euro area sovereign spreads, as well as euro area sovereign CDS spreads, have narrowed further, in some cases to pre-Lehman levels, until very recently, when a few have widened again. Looking ahead, the prospects for euro area government bonds continue to be surrounded by persistent uncertainty about future macro-financial developments. Upward risks to yields could stem from a further unwinding of flight-to-safety and flight-to-liquidity flows. In addition, slower than expected growth might increase the financing needs of euro area governments and bond markets might face difficulties in absorbing higher government bond issuance.
As I initially explained, the institutional reforms that have been adopted or are being adopted to establish a banking union constitute important progress. But to meet the ultimate objective of strengthening financial stability, implementation is key. And implementation is well under way: the Supervisory Board has held its first three meetings; a Framework Regulation has been prepared and is now the subject of a public consultation; and work is progressing on the supervisory model of the SSM with the Supervisory Manual. One of the first major implementation tests is the comprehensive assessment, the health check of the euro area banking system, which is currently being conducted as a prelude to the SSM becoming operational. Here, the ECB is making good progress in establishing the new structures and ensuring that the exercise will be fair, transparent and stringent. But many more steps still lie ahead of us. A final challenge relates to the macro-prudential arm of the SSM. As you know, the SSM Regulation gives the ECB the power to apply stricter macro-prudential measures than the national authorities if it deems them necessary. We can also advise on the calibration of instruments. This goes some way towards insuring against an inaction bias at the national level, thus improving the prospects for a more stable euro area financial system. We will maintain a clear separation of objectives between the macro-prudential policy framework and monetary policy and a clear hierarchy, with price stability remaining the ECB’s overall primary objective.