Why The "Time Is Up" For Europe's Peripheral Bond Rally

By Bloomberg macro and Market Live commentator Kristine Aquino

Time’s Up for Euro Area Periphery Bond Rally

The world-beating run for euro-area periphery bonds is coming to an end. Yields are likely to finish 2018 higher and spreads to core securities will probably widen as the conclusion of quantitative easing exposes bloated debt burdens amid slowing economic recoveries. After all, we’re talking about a group of nations that includes three (Greece, Italy and Portugal) of the five most-indebted countries in the developed world, as measured by debt-to-GDP ratios.

Portugal’s bonds had a huge rally in 2017 as the nation’s progress on managing its debt load helped it win back investment-grade status with Fitch and S&P. But investors had anticipated the upgrades long before they came about, curbing the likelihood of the bonds benefiting from any extra follow-through.

And the economic environment there and elsewhere in the region is likely to become more challenging this year. Growth for most of the periphery will either slow, or be little changed, in the next two years, according to analyst estimates compiled by Bloomberg.

In 2018, Italy’s real (inflation-adjusted) GDP is forecast to fall 0.2 percentage points, while a 0.6 percentage- point decline is seen for Portugal and Spain.

Greece is the exception, with real GDP expected to rise 0.9 percentage points, though that follows consecutive declines in six of the past eight years.

Those economic fundamentals are likely to become a larger influence on investor appetite for the debt as the end of the ECB’s bond-buying program looms. Given that’s likely to lift yields on benchmark German debt, it’s likely to raise rates for periphery nations too.

And since QE arguably benefited periphery debt the most, the end of central-bank debt purchases also risks dimming periphery bonds’ appeal on a spread basis. Italy and Spain are also particularly vulnerable to idiosyncratic political risks in the medium term.

The aftermath of December’s Catalan election, where separatists garnered a majority, may provoke another flare-up for Spanish bonds. While the 10-year yield spread over Germany has receded from levels seen in October, when the region’s latest secessionist push came to a head, it’s yet to return to last year’s tightest levels.

Over in Italy, the peak of political risk will come later in 1Q, around the time of the March 4 election. The euroskeptic Five Star Movement leads in the polls and a protracted campaign may boost its prominence.

Together, there are considerable challenges for euro- area periphery bonds in 2018. With two-year yields negative in all those countries apart from Greece, the bar is too high for them to repeat their outperformance since the end of the region’s sovereign debt crisis.