Spanish Bonds Show Belief Firewalls Can Resist Greek Fallout

To see how well equipped the euro area is to survive a Greek exit from the currency bloc, look no further than the bond market.

While Spanish and Italian government bonds plunged when markets opened on Monday, they pared losses quickly in a signal of investors’ faith in firewalls designed to contain such an event. That left Spain’s 10-year securities on course for their worst day in just two weeks, allaying concern that Greek could spark an aggressive selloff across its euro-area neighbors.

“So far the firewalls appear to be working,” said Owen Callan, a fixed-income strategist at Cantor Fitzgerald LP in Dublin. “The market is not worried about negative moves per se, it’s more worried about any panic moves suggesting contagion, which so far are not that obvious.”

Spain’s 10-year bond yield rose 14 basis points, or 0.14 percentage point, to 2.25 percent as of 10:58 a.m. London time, set for the biggest increase since June 15. The yield earlier climbed as much as 49 basis points.

In five months of brinkmanship on Greek debt, losses outside of Greece have been relatively muted, as crisis backstops combined with bond purchases under the European Central Bank’s quantitative-easing plan to limit contagion. Earlier in the decade, the government debt of all but the safest euro-zone nations sold off as economic turmoil that started in Greece raised concern the euro area would splinter.

What’s Changed?

Although Spanish and Italian bond yields have climbed from record lows as tension in Greece rose, there have been few signs of panic among investors. The biggest daily increase in Spanish 10-year yields this month was the 16 basis-point jump on June 15. In 2012, that wouldn’t have been in the top 25 worst days.

The extra yield investors demand to hold Spanish 10-year bonds instead of their German equivalents, a measure of the securities’ risk, was at 147 basis points on Monday. In 2012, when investors feared a Greek exit would spark a domino effect and fracture the euro area, the spread reached 650 basis points.

What’s changed is the construction of a series of firewalls to guard against contagion, starting with ECB President Mario Draghi’s pledge in July 2012 to do whatever it took to save the euro, made the day after the Spanish-German yield spread reached its euro-era high.

European Backstops

Since then, Europe’s policy makers have put in place systems to centralize bank supervision and weaken the link between troubled debtors and taxpayers. A permanent bailout fund, the European Stability Mechanism, was established, succeeding the previous European Financial Stability Facility.

Another prop is coming from the ECB’s purchases of 60 billion euros ($67 billion) of debt each month -- a move intended to stimulate the economy rather than stem contagion -- that helps limit the effect of any selloff in government bonds.

The ECB’s Governing Council agreed on Sunday to freeze the level of emergency aid available to Greek banks.

“The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area,” it said in a statement. It’s “determined to use all the instruments available within its mandate,” it said.

The establishment of firewalls has made lawmakers across Europe more confident that a Greek exit from the euro area -- a violation of one of the currency bloc’s key principles -- can be survived without the sort of catastrophe triggered when Lehman Brothers Holdings Inc. collapsed in 2008.

No Lehman

Following the announcement of Greece’s referendum on the conditions international creditors required in return for financial aid, euro-area finance ministers discussed the likelihood of knock-on effects for the rest of the region, according to Ireland’s finance minister Michael Noonan.

“The assessment was that we are in a much better position than we were following the collapse of Lehman Brothers, when Europe was caught unprepared,” he told reporters in Brussels on Saturday. “Since then there is a fiscal union virtually in place. There is a banking union almost completed and in place. EFSF had been established. More importantly also the ESM has been established. There are structural changes and financial buffers on place. So there is no level of anxiety.”

So far, what Noonan says rings true, judging by bond markets. Italy’s 10-year bond yield was 15 basis points higher at 2.30 percent on Monday, having pared an earlier increase of as much as 57 basis points. While the yield is up from a record-low 1.031 percent set on March 12, it compares with a five-year average of 4.17 percent.

“The ECB has the firepower to limit damage on other peripheral countries,” Nick Stamenkovic, a fixed-income strategist at broker RIA Capital Markets Ltd. in Edinburgh, said on June 27. “Indeed, the adoption of sovereign QE by the ECB is a game changer, limiting potential upside on peripheral yields.”

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