Bonds Show Crisis Return When ECB Loans Expire
European Central Bank President Mario Draghi’s unlimited three-year loans to euro-region banks may give Italy and Spain only temporary respite from the region’s debt crisis.
Two-year Italian and Spanish notes rallied since the ECB said Dec. 8 that it planned to offer as much liquidity as banks wanted in exchange for eligible collateral. The gain on the short end of the market outpaced longer-dated debt on concern the nations’ austerity plans won’t plug deficits and reduce Europe’s largest debt load. Yields on Italian two-year notes fell to the least relative to 10-year bonds in 21 months.
“This is about buying time,” said John Davies, a fixed- income strategist at WestLB AG in London. “It’s only when the market believes Italy and Spain have returned to sustainable debt levels that you can say the crisis has truly ended.”
Investor demand at sales of government bills and short-term debt has increased across the euro region since the ECB injected 489 billion euros ($632 billion) of three-year loans into the financial system on Dec. 21. The loans were offered at the benchmark rate, currently 1 percent, enabling financial institutions to profit by lending the cash at higher rates, including to governments. The banks that borrowed the cash may also use the funds to finance their own maturing debt.
Rates on two-year Spanish notes dropped to as low as 2.80 percent on Jan. 13, the least since November 2010, from a euro- era record of 6.12 percent on Nov. 25. The declines widened the difference in yield between two-year notes and 10-year bonds to 223 basis points on Jan. 11, the most since March, based on closing-market rates. The yield spread was 206 basis points, or 2.06 percentage points, at 12:32 p.m. London time, compared with an average over the past five years of 142 basis points.
Italian and Spanish notes rallied on Jan. 12 after borrowing costs for both nations declined at auctions of short- dated debt. Italy sold 12-month bills at a yield of 2.735 percent, down from 5.952 percent at the previous auction. Spain sold a new benchmark three-year note at an average yield of 3.384 percent, down from 5.187 percent at an offering of similar-maturity securities on Dec. 1.
“For the time being, the ECB’s operations are working at the short end, but for the long end, we have a lot of uncertainties around,” said Frankfurt-based Werner Fey, a fund manager at Frankfurt Trust Investment GmbH, which oversees the equivalent of 6.5 billion euros of fixed-income assets.
While Fey said he’s more likely to buy Spanish and Italian paper now, “the government problems for the euro-sovereigns are unresolved and so we are still on the cautious side. We have an underweight bias on the longer-term maturities,” he said.
Even after the first three-year loan operation, the ECB has been buying bonds, using its Securities Market Program (ECBCSMPW) to keep a lid on yields. It settled 3.77 billion euros of bond purchases in the week ended Jan. 13, up from 1.1 billion euros the previous week.
Spain’s 10-year bonds slid yesterday after the debt agency agreed to sell more than its target amount of securities due between 2016 and 2022, amid speculation the government is rushing to raise money should it miss deficit targets. Spain has completed 19 percent of its gross funding needs for the year, up from 9 percent at the same time in 2011, according to Credit Agricole Corporate & Investment Bank.
The Spanish government said Dec. 30 that its 2011 deficit would reach 8 percent of gross domestic product, exceeding the European Union’s 6.6 percent forecast, after growth stalled. While Italy’s deficit was likely to shrink last year to 4 percent from 4.6 percent a year earlier, according to the EU’s projections, its debt load, estimated at 120.5 percent of GDP last year, is almost double the 69.6 percent forecast for Spain.
Bringing down yields beyond the period covered by ECB loans may only be possible with evidence that nations are successfully implementing measures needed to both control spending and ensure growth, WestLB’s Davies said.
The ECB loan does “nothing to bring down debt levels, it’s a liquidity measure to try to buy time to manage the solvency issue,” he said.
Plans to trim spending and curb deficits risk falling short as the euro-region economy contracts. The 17-nation region is forecast to shrink 0.2 percent this year, while the U.S. economy will probably expand 2.3 percent and the U.K. economy will grow 0.6 percent, Bloomberg surveys show.
While Italy’s government is basing its budget program on a worse-case scenario for a 0.4 percent to 0.5 percent contraction in GDP this year, the Bank of Italy said Jan. 17 that the economy may contract as much as 1.5 percent.
“Confidence won’t be restored if growth is falling,” Nobel Prize-winning economist Joseph Stiglitz said on Jan. 18. “Austerity on its own won’t bring growth.”
The need to promote an expansion may keep the pressure on the central bank as it prepares for a second offering of three- year loans next month.
“I see no short-term solutions to the sovereign crisis, so the ECB must buy time for the governments to work on their consolidation,” said Frankfurt Trust’s Fey. “The ECB will continue to expand its balance sheet. They will probably have to step in and support the long-end of the curve too.”
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