After dodging a bullet before the holidays, Europe’s peripheral nations are once again getting punished in the bond markets. The spreads between German government bonds and the peripheral nations are close to record highs. Portuguese 10-year government bond yields (up 70 basis points this week) are now at critical levels. The government in Lisbon has said that 7 per cent is the threshold at which it would need to consider taking a bailout. Currently yields are 7.11 per cent, so it seems only a matter of time before Portugal is negotiating with the ECB, EU and the IMF and receiving funds.
Another worrying development is Belgium. Although it isn’t a core economy, it wasn’t considered a basket case either. Back in August its 10-year bond yield fell to 2.8 per cent, yet it is now above 4 per cent and has risen in line with other peripheral nations. So will the home of the European Union be forced to negotiate a bailout for itself in the coming months?
There are three main reasons that investors have targeted the peripheral nations bonds with such gusto since the start of this year. The first is a wave of supply that is about to come onto the market. On 12 January Portugal will offer 2014 and 2020 bonds for auction, Italy and Spain are also holding auctions at the latter part of next week. Investors charged a hefty premium to hold short-term Portuguese bonds in an auction last week, which doesn’t bode well for the upcoming debt sales. The news that the world’s largest bond fund will not be participating in the upcoming bond auctions is another red flag in our opinion as it points towards a buyers strike. If Portugal and Europe’s other weak nations have to pay a higher yield to attract investors to purchase their debt, soon people will worry about the impact higher debt payments will have on growth, causing more investors to ditch their debt and yields to rise and so on. This seems like the start of a debt spiral to us. Next week could see some real fireworks, and bond spreads are close to breaking fresh Euro-era highs.
Belgium’s problems are actually more political. It is currently without a full-time government and seven political parties are locked in discussions trying to form a government and overcome the political impasse. This is bad timing to have political meltdown as Belgium is finding out. Investors aren’t in the mood to suffer risks within the Eurozone easily and until a fulltime government is found it is unlikely there will be a let-up in the pressure on Belgium’s bonds.
Another factor weighing on sentiment toward the periphery is the European Commission’s plans to overhaul the governance of Europe’s banking sector. One of the proposals is to give regulators the power to write down senior bank debt by any amount necessary, or to convert bank debt into equity if a bank were to get into trouble. Until the risks to the investor are set in stone, European debt is an unattractive asset to hold.
The sovereign debt crisis in Europe appears to be spilling over to the euro. EURUSD is currently below 1.3000, and if the sovereign debt crisis is poised to get worse then it will be hard to muster up much enthusiasm for a stronger euro and we could see a continuing grind lower in the single currency. A convincing break below 1.2960/65 could herald losses toward 1.2900 then 1.2650 – the lows reached back in October. But the decline may not be in a straight line due to continuing demand for the single currency from Asian central banks that want to diversify away from the dollar.
