The first debt auction after the election of Mariano Rajoy’s Popular Party saw Spanish borrowing costs surge to 14-year highs. The rate Madrid had to pay for 3-month bills was a staggering 5.1% up from 2.3% at an auction last month. 6-month bills saw yields jump nearly 2% in 4-weeeks to 5.2%. The demand for debt was fairly strong although that was mostly because Spanish banks (already over-burdened with sovereign debt) pledged to support the auction.
Europe’s sovereign debt problem is now chronic. Although the Spanish government continues to say that it can cope with this surge in bond yields it might not be able to stay afloat for that long. Next year Spain has to refinance EUR 140bn of debt, and EUR 30bn of that is in the first quarter. At the current 10-year bond yield of 6.6% its interest cost on debt issued next year would be EUR 10 bn. With an unemployment rate of 22.2% and a projected growth rate next year of a mere 1.1% (according to estimates by the IMF) higher borrowing costs erodes growth prospects even more leading to a vicious debt spiral of rising bond yields and a worsening growth outlook.
As we have said before once a sovereign crisis takes hold it is very difficult to reign it back in. But even though Spain’s new Prime Minister elect has pledged to enact growth and fiscal reform the bond markets are still punishing Madrid. So why is this? Either the markets have little faith that true reform can take place in some of Europe’s overly indebted Southern states, or it is because there is no “lender of last resort” or ultimate financial backstop in place in the currency bloc, the absence of which threatens its very survival.
I tend to lean towards the latter explanation. Although the UK and the US have very high debt burdens the bond vigilantes have left Treasuries and Gilts alone, which are still attracting safe haven flows as investors dump Eurozone bonds. This is because the Bank of England and the Federal Reserve are both financial back-stops for the economies.
But while it may be glaringly obvious to the market that there is a vital missing piece of the Eurozone jigsaw, Germany seems to be oblivious. The head of the Bundesbank came out today and said that the ECB can’t be the lender of last resort for the currency bloc and that monetary financing will not solve this crisis. He added that Spain and Italy can sort out their problems without outside help. This laissez-faire attitude could come back and bite Germany since it could be left to step in when things get critical. But right now that is unlikely to happen. German Chancellor Merkel said that there is no big bazooka forthcoming to solve this crisis. So if Germany isn’t willing to step up to the plate what will happen?
The honest answer is that we don’t know. It appears that Germany et al want to keep the Eurozone together, which means that when things get really bad they tend to step in and bring out the big guns. So their inaction right now suggests a couple of things: either Europe’s pain threshold has been raised or traders and investors have to adapt to this “chronic” condition in the markets, with the bond markets being the epicentre of the stress in the Eurozone and stocks and FX experiencing extra volatility and range-trading conditions for some time.
The market remains short euro and the latest CFTC data on speculative positioning shows that short euro positions are close to their highest level since mid-2010, this suggests that Europe’s “chronic” condition will equate to a slow grind lower for the single currency rather than outright collapse. EUR/USD and EUR/JPY will take the brunt of selling with EUR/GBP and EUR/AUD tending to move in line with risk sentiment for the medium-term. EUR/USD bounced off recent lows and is currently above 1.3550. However, we tend to think that 1.3500 is a resting spot for the cross before it embarks on a meander towards the 1.3150 lows from mid-October.
Elsewhere, there was some rare good news for the UK economy this morning. Borrowing figures were lower than expected in October at GBP6.5bn, less than the GBP7.7bn last year. If this is sustained then full-year borrowing could come in GBP3bn below the GBP122bn estimate for this fiscal year. However, a counterbalance to these better borrowing figures is a weaker growth profile and a rise in the unemployment rate that could boost welfare payments in the coming months. The UK is not out of the woods, but - thankfully for Westminster - the bond markets haven’t yet put pressure on the government to tighten fiscal plans to mitigate against rising welfare payments.
The pound is moving with general risk appetite today, which has picked up after yesterday’s rout in stocks. Right now the bond market continues to show signs of stress: Spanish, Italian and French bond yields are all higher today. However, stocks are taking a breather and European indices are up about 1%, this has been followed by a better tone to risky FX. However, we prefer to trust sentiment in the bond market, which is still very weak. This makes further volatility in asset markets highly likely.
Ahead today the second reading of US GDP is expected to remain unchanged at 2.5%. Expect headlines to dominate price action. The latest news has helped to calm the market mood today after EU Council President Juncker said that Greece is likely to receive its next tranche of bailout funds and Merkel, Sarkozy and new Italian PM Monti will hold a joint-press conference on 24th November – standing shoulder-to-shoulder.
Europe’s sovereign debt problem is now chronic. Although the Spanish government continues to say that it can cope with this surge in bond yields it might not be able to stay afloat for that long. Next year Spain has to refinance EUR 140bn of debt, and EUR 30bn of that is in the first quarter. At the current 10-year bond yield of 6.6% its interest cost on debt issued next year would be EUR 10 bn. With an unemployment rate of 22.2% and a projected growth rate next year of a mere 1.1% (according to estimates by the IMF) higher borrowing costs erodes growth prospects even more leading to a vicious debt spiral of rising bond yields and a worsening growth outlook.
As we have said before once a sovereign crisis takes hold it is very difficult to reign it back in. But even though Spain’s new Prime Minister elect has pledged to enact growth and fiscal reform the bond markets are still punishing Madrid. So why is this? Either the markets have little faith that true reform can take place in some of Europe’s overly indebted Southern states, or it is because there is no “lender of last resort” or ultimate financial backstop in place in the currency bloc, the absence of which threatens its very survival.
I tend to lean towards the latter explanation. Although the UK and the US have very high debt burdens the bond vigilantes have left Treasuries and Gilts alone, which are still attracting safe haven flows as investors dump Eurozone bonds. This is because the Bank of England and the Federal Reserve are both financial back-stops for the economies.
But while it may be glaringly obvious to the market that there is a vital missing piece of the Eurozone jigsaw, Germany seems to be oblivious. The head of the Bundesbank came out today and said that the ECB can’t be the lender of last resort for the currency bloc and that monetary financing will not solve this crisis. He added that Spain and Italy can sort out their problems without outside help. This laissez-faire attitude could come back and bite Germany since it could be left to step in when things get critical. But right now that is unlikely to happen. German Chancellor Merkel said that there is no big bazooka forthcoming to solve this crisis. So if Germany isn’t willing to step up to the plate what will happen?
The honest answer is that we don’t know. It appears that Germany et al want to keep the Eurozone together, which means that when things get really bad they tend to step in and bring out the big guns. So their inaction right now suggests a couple of things: either Europe’s pain threshold has been raised or traders and investors have to adapt to this “chronic” condition in the markets, with the bond markets being the epicentre of the stress in the Eurozone and stocks and FX experiencing extra volatility and range-trading conditions for some time.
The market remains short euro and the latest CFTC data on speculative positioning shows that short euro positions are close to their highest level since mid-2010, this suggests that Europe’s “chronic” condition will equate to a slow grind lower for the single currency rather than outright collapse. EUR/USD and EUR/JPY will take the brunt of selling with EUR/GBP and EUR/AUD tending to move in line with risk sentiment for the medium-term. EUR/USD bounced off recent lows and is currently above 1.3550. However, we tend to think that 1.3500 is a resting spot for the cross before it embarks on a meander towards the 1.3150 lows from mid-October.
Elsewhere, there was some rare good news for the UK economy this morning. Borrowing figures were lower than expected in October at GBP6.5bn, less than the GBP7.7bn last year. If this is sustained then full-year borrowing could come in GBP3bn below the GBP122bn estimate for this fiscal year. However, a counterbalance to these better borrowing figures is a weaker growth profile and a rise in the unemployment rate that could boost welfare payments in the coming months. The UK is not out of the woods, but - thankfully for Westminster - the bond markets haven’t yet put pressure on the government to tighten fiscal plans to mitigate against rising welfare payments.
The pound is moving with general risk appetite today, which has picked up after yesterday’s rout in stocks. Right now the bond market continues to show signs of stress: Spanish, Italian and French bond yields are all higher today. However, stocks are taking a breather and European indices are up about 1%, this has been followed by a better tone to risky FX. However, we prefer to trust sentiment in the bond market, which is still very weak. This makes further volatility in asset markets highly likely.
Ahead today the second reading of US GDP is expected to remain unchanged at 2.5%. Expect headlines to dominate price action. The latest news has helped to calm the market mood today after EU Council President Juncker said that Greece is likely to receive its next tranche of bailout funds and Merkel, Sarkozy and new Italian PM Monti will hold a joint-press conference on 24th November – standing shoulder-to-shoulder.