The cost of servicing European governments’ debt relative to Germany could halve by the end of 2009, as expectations of economic recovery unwind safe haven flows.
Spreads fell from euro lifetime highs in the past week, driven narrower by the prospect of European governments’ stimulus plans kicking in and helping unwind the flows into safer haven German Bunds as well as improved market liquidity.
Germany has the highest liquidity debt market and lowest yields in the euro zone and is viewed as the yardstick for measuring the performance of other euro zone sovereigns’ debt yields. “German bonds virtually own the liquidity premium and if the world economy picks up, the size of that premium evaporates,” said David Keeble, head of fixed income strategy at Calyon in London.
Even if the euro zone’s economy continues to worsen from here, Germany will entice spread narrowing, now that the initial shock of recession is priced in by financial markets. “Germany is perceived as a quadruple-A credit, which is not in tune with reality.
Therefore if the German economy weakens you will get lower yields but the declines would not be as much as for other sovereign issuers,” Keeble explained. “By year end I can see the spreads halving as people realize that Germany, the benchmark sovereign for sizing up others’ debt, is not itself the top-notch economy,” he added.
Growing optimism the global economy may be nearing the end of its gloomiest patch in more than 60 years and debt markets trying to price in the future course of events has helped narrow spreads between so-called peripheral euro zone bond yield spreads and core German paper.
“The spread of peripheral sovereign debt over Germany has become an indicator of financial risk since last October and a barometer of global economic health,” said Philip Shaw, chief economist at Investec in London. “If spreads narrow, the economy improves.”
The significance of that for investors is that holding back from buying peripheral debt in the hope of spreads widening further and cheapening the paper versus Germany is no longer a profitable strategy. And for issuers that can mean lower funding costs so long as the general level of euro zone debt yields is also falling.
Germany may be a safer bet than higher-yielding sovereign debt elsewhere in Europe, but it could suffer when the recovery comes and massive flight-to-quality trades of the past year -- which drove two-year German bond yields to an all-time record low in January -- are unwound, driving Bund yields higher, peripheral debt yields lower and spreads narrower.
Defying those who reckoned on spreads widening further and threatening the break-up of the European Union’s currency pact, both euro zone and non-euro zone sovereigns have seen 10-year debt yield spreads over benchmark German Bunds decline in the past week almost as dramatically as they widened earlier in January.
Greece, whose 10-year government debt yield in January scaled a euro lifetime record 300 basis points over German Bunds a week after Standard & Poor’s downgraded the sovereign’s debt, was at 227 bps on Thursday - its narrowest in nearly a month. “Maybe not 60 basis points -- where the spread was in mid-2008 -- but we could certainly see the Greek spread closer to 200 than 300 basis points this year,” said Investec’s Shaw.
Even Spain, the euro zone’s fourth-largest economy licking wounds after Standard & Poor’s also downgraded its debt ratings last month, fell to 92 bps on Wednesday, compared with 126 bps in the aftermath of its ratings cut. The downgrade did not prevent Spain from launching a syndicated 10-year government bond this week, in the face of up to €5 billion of three- and five-year Spanish debt being auctioned earlier this session.
That confidence paid off: Spain managed to sell €7 billion of the paper on Tuesday - the largest haul for a Spanish syndication ever - and at the tighter end of price guidance. Spain, like other sovereigns in Europe, faces vast needs for cash to finance bank recapitalizations in the ongoing credit crisis and to prop up a recession-hit economy.
The euro zone is seeking to raise at least 10% more debt this year than in 2008, and worth up to €900 billion in total. Supply even turned into something investors don’t sigh about.
Last week was a turning point in debt issuance’s popularity. “Concession building” was not only absent ahead of the auction of reopened three-year Italian BTPs last week, the bonds traded higher in the secondary market as peripheral paper was popular again and worries about Germany’s economy haunted investors.
“The events of last week do mark something of a turning point," said Wilson Chin, a bond strategist at ING in Amsterdam. "Spreads have tightened quite dramatically. There are worries about Germany itself. But I am not too optimistic they will continue to narrow from here. The market remains quite nervous,” he added.
Risks still abound. If US President Barack Obama’s economic stimulus package stalls in Congress, or more credit risk emanates from the start of the banking sector reporting season next week, spreads could arrest further narrowing in the short term and might even blow out again. But the direction looks set to be one of narrowing yield spreads. (Reuters)