2013-01-22 11:56:04
Government-bond markets in peripheral countries are soaring
Jan 19th 2013 |From the print edition
THE squiggles on traders screens showing changes in the prices of government
bonds are the closest thing that financial markets have to ECG machines for
economies. By this diagnostic measure the invalids in Europe s medical ward are
making a remarkable recovery.
On January 10th the interest rate on Spanish ten-year government bonds fell
below 5% for the first time in almost a year. Even though rates then ticked up
a tad, the cost of new government borrowing is now about 2.5 percentage points
lower than it was when worries over a break-up of the euro area peaked in July
2012 (see left-hand chart). The Italian patient is doing well too. The rate on
ten-year Italian debt is approaching 4%, which is also close to 2.5 percentage
points off the highs last year.
Other measures show improvement as well. Big banks in Italy and Spain are
managing to sell long-term bonds. European banks also seem likely to reduce
their dependence on the lifeline extended by the European Central Bank (ECB)
through its long-term refinancing operations. Huw van Steenis, an analyst at
Morgan Stanley, reckons that banks (mainly those in the core of Europe) may
repay 100 billion-200 billion ($133 billion-266 billion) of the 1 trillion in
cash they borrowed from the central bank in 2011 and 2012. Mario Draghi, the
president of the ECB, says that a positive contagion is sweeping through
Europe. The idea has some merit, but is the region really on the mend?
The first cause for investor optimism stems from the assurances by Mr Draghi
that the ECB will do whatever it takes to save the euro. That sparked a burst
of bond-buying by hedge funds that were covering short positions in Italian and
Spanish debt. I d say that 80% or 90% of the juice is gone from a [euro]
collapse trade, says one fund manager.
Institutional investors such as pension funds and insurers are now also
returning to these markets. Part of the explanation for this is that Spanish
and Italian bonds still offer juicy yields, even when adjusted for the risk of
default, compared with depressed rates on other assets.
Mr Draghi s positive contagion may also play a role. Prices of government bonds
do not simply reflect the underlying health of government finances, they also
influence them. In the cases of both Spain and Italy debts that appear
sustainable at interest rates of 3-4% become unsustainable if rates move
persistently to 6-7%, making it rational for investors to keep selling bonds
even as they get cheaper. In turn, cautious investors such as insurers tend to
sell bonds that display high volatility or that fall rapidly in price because
these variables affect their internal measures of risk.
Such technical factors can also reverse, says Andrew Balls of PIMCO, a
bond-fund manager that has been buying Spanish and Italian bonds for some
months now, having previously sold much of its holding. When [bond] prices are
falling people want to sell, and that can also work in the opposite direction,
says Mr Balls. If bond yields continue to be steady or decline, if volatility
continues to be steady or declines, then you can crowd investors in.
Confidence in bond markets is being seen as a turning-point in the crisis. Yet
some of the vital signs may be misleading. One worry is that the connection
between weak banks and weak governments may have strengthened again in recent
months. Bond traders suspect that much of the demand for Spanish and Italian
government debt in recent months has come from the domestic banks of these two
countries.
Barclays reckons that some of this was facilitated by the recent
recapitalisation of weak Spanish banks. Anecdotally one sees that when there
is a Spanish holiday [and no Spanish bond-buyers] there is a widening of
spreads, says one investor. Although there are signs of revived interest from
foreign investors, they seem to be buying bonds that will mature soon (and thus
are potentially protected by ECB bond purchases under its Outright Monetary
Transactions programme).
The underlying economic picture remains grim. Germany s economy contracted in
the fourth quarter. Unemployment is extremely high in peripheral countries,
stoking fears of unrest. Spain and Italy risk missing their deficit-reduction
targets. Small firms in both countries are suffering from a drought in bank
finance; when they can borrow, they pay through the nose. Output in much of the
periphery is forecast to shrink this year (see right-hand chart).
Most worrying of all is that the fall in yields may blunt the incentive for
euro-zone politicians to take tough decisions on reforms. European
policymakers only move at gunpoint, and the only gun around is the market,
says Willem Buiter of Citigroup. The fact that sovereigns take a holiday from
painful decisions every time the pressure is off is one reason why positive
contagion is very harmful.