Eurozone Debt Crisis 2.0: Debt Markets Face A Summer Storm If ECB Fails to Announce QE

20th May 2014 By: Eimear Daly

Peripheral bond and debt markets

  • This weekend Der Spiegel quoted ECB’s Chief Economist Peter Praet saying quantitative easing of either sovereign or corporate bonds won’t be on the agenda for the June 5th meeting. Peripheral Eurozone sovereign debt immediately came under pressure on Monday morning with Spanish 10 year yield up 4 basis points, Portuguese up 5 basis points and Italian, the most susceptible, with financing costs higher by 8 basis points. These small market moves are a preview to a potentially bigger problem on the horizon.
  • Peripheral bond markets were still recovering from a sell-off on Thursday 15th, after news broke that Greece was planning to introduce a retroactive capital gains tax on foreign holders of bonds, later denied. While Greece 10 year yields spiked 50 basis points, the most worrying dynamic was a spillover into Spanish, Italian and Portuguese bond markets, showing that debt market contagion is still alive and well. Trouble in one sovereign bond market will set off a domino effect across all peripheral debt markets.
  • Eurozone peripheral debt markets are one big bet on ECB Quantitative Easing. Irish 10 year Treasury yields only 30 basis points above US Treasuries and Italian 10 year yield at its lowest level on record are just some of the anecdotal evidence that shows investors are overlooking fundamentals driven by speculative exuberance.
  • The Bank of Italy reported foreign holdings of Italian debt rose to €44billion in the 12 months to February, compared to just €7.9billion in the same period last year. Non-resident holding of Italian government debt rose to 27%, up 0.9% in December 2013.
  • Foreign capital inflows aren’t just confined to debt markets. Overall portfolio investment in Italy rose to €58 billion in the year to February, compared to a mere €19.6 billion in the same period last year. Foreign capital is far more likely to flee on a change in investor appetite, leaving peripheral markets highly exposed to swings in risk sentiment.
  • Overall peripheral debt markets are reporting increased liquidity on the secondary market, rising trading volumes and a significant narrowing in the bid-ask spread as the prospect of ECB QE encourages speculative investors.

Speculative bets on QE

  • Speculative bets on Eurozone QE have spread further. Investors eagerly returned to emerging market assets from February as rumours of ECB QE gained traction. Effectively investors were betting that ECB QE would offset the decline in the US programme and they could continue to overlook fundamentals for return as capital was forced out of eurozone markets. Sharp appreciation in currencies such as ZAR and MYR suggest a high level of complacency in these trades, as macro fundamentals deteriorate further.
  • Volatility is extremely cheap as the liquidity trade covers over the cracks in fundamentals and escalating geopolitical tensions. Historically low levels of volatility precede sharp sell-offs or crisis such as in the run up to the 2008 financial crisis or right before Bernanke’s May tapering speech.

Exchange rate

  • The rally in Eurozone peripheral debt occurred pari passu with the climb higher in the euro exchange rate, as capital inflow into eurozone assets supported the common currency.
  • There is a significant negative correlation of -0.16 between the average 10 year yield of the five programme nations and the euro from start of the euro debt crisis in 2010. An even stronger negative correlation exists between euro-dollar and the Spanish and Italian 10 year yield, both -0.20. This underlines the fact that the euro trades as its weakest link, not the eurozone average.
  • There is a concerning conclusion from this. As long as the euro’s correlation to peripheral yields hold, ECB quantitative easing could actually strengthen the euro and not weaken it. This implicitly makes the ECB less likely to implement the policy and explains their emphasis on the exchange rate, not disinflation at the May policy meeting.

ECB inaction

  • The reality is the Eurozone doesn’t have the same capital market infrastructure as the US or the same stock market culture. The Eurozone financial system is more comparable to that of the UK. The Bank of England’s aggressive quantitative easing programme corresponded to a strengthening in sterling’s real effective exchange rate, not a devaluation. QE arguably attracted in foreign capital and did not force it out. This is most evident in the housing market..
  • The ECB failing to implement QE this summer could lead to the “Eurozone debt crisis 2.0”, albeit not as pronounced as the market rout from 2010. Italian and Portuguese debt markets are the most susceptible to a sell-off if QE doesn’t materialise but all peripheral economies are likely to experience higher financing costs. ECB inaction however will cause ripple effects that spread beyond the Eurozone border. We may well see a reversal of the strengthening in EM assets experienced since February with markets finally focusing on fundamentals with expectations of continued central bank liquidity behind them.

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