The more things are bankrupt, the more things stay the same. Evidence #1: Goldman's FUG (Francesco U. Garzarelli) sends a letter to clients in which he implies that Europe should promptly add Portugal and Ireland to its list of wards of the state, so that the Dow can go back to targeting 36,000 on short notice. Apparently this latest European nuisance (punctuated by the Irish Bund spread passing 600 bps) is too much for Goldman strategists, who are perplexed by this stunning inability of the ECB and EMU to grasp that in this market where the only buyer of everything are Central Banks and no market risk is supposed to exist, that Europe still has refused to step up to the plate and debase their currency by a few hundred bips. And after all, the only reason the EURUSD is trading where it is, is so that it has a whole lot of buffer room to fall.
After trading mostly in response to country-specific dynamics, as testified by the rally in Greece and the concomitant sell-off in Ireland between August and mid-October, sovereign EMU spreads have again become more correlated. To illustrate this, Kamakshya Trivedi has run a ‘principal component analysis’ on 10-yr government bond spreads between Germany and Italy, Spain, Ireland, Greece and Portugal to isolate the portion of the country spread variance explained by a ‘common factor’ on a 1-month rolling basis. This statistic has increased steadily since the middle of October, suggesting greater co-movement (interestingly, the implied correlation of stocks within the Eurostoxx 50 continues to moderate, in contrast to previous relationships to sovereign issues).
It is difficult to ascertain whether the increasing pressures on Ireland and Portugal have simply ‘spilled over’ or the market has built in more systemic risk after the restructuring facility proposals dating back to 29 October. It is probable that the timing of the German proposals has amplified the underlying concerns surrounding the two peripheral EMU countries (Ireland and Portugal) with oversized debt relative to the domestic ability to roll it over. The result is that the secondary market for these issuers is distressed, requiring ongoing direct intervention from the ECB.
In our assessment the ECB’s desire to regain control over overnight rates, reflecting the brightening in the growth outlook, and the discussions on strengthening the Eurozone fiscal governance structure and creating a credible mutual support scheme are both, on balance, supportive for sovereign spreads. But these developments have also raised near term uncertainties. As the experience of Sweden has recently shown, short rate volatility can increase substantially when excess liquidity is reduced, while the different proposals for sovereign restructuring schemes may sound like a cacophony in the ears of investors.
This leaves Ireland and Portugal exposed to an intensification of market pressures, increasing the probability that both Ireland and Portugal will need to apply for external support and funding from the EFSF, as Erik Nielsen has also argued in his commentary lately. We think such an outcome would reduce sovereign risk tensions where they are still brewing and lead to a broader compression in sovereign spreads. We note the following:
- Greece, Ireland and Portugal (the ‘outer periphery’) have different problems, but can be grouped together in terms of small size, foreign distribution of debt, and low capacity of the domestic private sector to re-absorb claims held by foreigners and at the same time finance the new deficit. History suggests that sovereign issues come in clusters, and since the Greek events this Spring, the market has increased the focus on the remaining two.
- Granted, Italy and Spain also have budgetary issues, but they are much bigger countries, with more diversified economies, and a deeper debt capacity. The market understands that an escalation of credit strains now experienced by Ireland and Portugal to these two sovereigns would command systemic repercussions. Based on the fiscal plans tabled by the respective governments, we very much doubt this is a scenario we will see unfolding.
- The borrowing power of the EFSM/EFSF (EUR 500bn) is vastly larger than the funding needs of Ireland and Portugal (we calculate that the combined total borrowing requirement, including redemptions, will not exceed EUR 150bn over the next 3-yrs). The cost of funds at the 5-yr maturity would currently be in the region of 2.3% (i.e., close to flat to mid-swaps). Assuming the charges for conditional funding are similar to Greece, the 5-yr EFSF lending rate would be in the region of 5% (mid-swap +300bp). By comparison, Irish and Portuguese 5-yr bonds trade at 6.9% and 5.5%, respectively, in the secondary market.
In conclusion, the combination of a more uncertain funding and evolving regulatory backdrop, together with ongoing tensions in the ‘outer periphery’, argue for an activation of the (conditional) mutual support framework agreed back in May. We think this would address the remaining sovereign liquidity issues in the Euro area, enable the ECB to relinquish the quasi-fiscal role it has assumed since the Greek debt crisis through its secondary market purchase of sovereign credit instruments, and finally allow the discussion on the Eurozone’s institutional setup to proceed in a more constructive environment.