Default Risk in Europe Nine Times Higher Than Treasuries After Greek Pact
The bailout that rescued Greece from a looming default has failed to restore confidence in credit markets, where traders are paying nine times more to insure European government bonds than they are for Treasuries.
While European stocks are off to their best start since 1998, the relative cost of credit default swaps has risen to a record, more than double the July level, according to CMA. To obtain 130 billion euros ($175 billion) in aid to help pay interest on bonds due March 20, Greek Prime Minister Lucas Papademos agreed to reduce debt to 120.5 percent of gross domestic product by 2020 from about 160 percent last year.
While chances of defaults and the breakup of the euro may have diminished, investors are no longer rewarding European governments for reducing spending to cut debt as their economies shrink. U.S. bond yields have stayed near record lows and growth is accelerating as President Barack Obama uses a different strategy, more than doubling the amount of outstanding debt to $10 trillion to fuel the recovery.
“Bond markets don’t believe in the same story that stock markets do,” Robin Marshall, director of fixed income in London at Smith & Williamson Investment Management, which oversees about $18 billion, said in a Feb. 22 interview. “Countries are still saddled with huge debt, are facing either economic downturn or recession.”
The Markit iTraxx SovX Western Europe index of default swaps linked to 15 nations from Finland to Italy rose 6.5 basis points in February to 345.5, up 33 percent since July, indicating a rising perception of risk. It reached an all-time high of 385 on Nov. 25. The cost of insuring U.S. debt dropped by more than 40 percent in that period. The ratio between the two rose a record 9.81-to-1 on Feb. 23, up from 4-to-1 seven months ago and 1.6-to-one in 2009.
The yield on the 10-year German bond, Europe’s benchmark government security, fell more than five basis points to 1.83 percent at 12:25 p.m. New York time, with the price of the 2 percent bund due in January 2022 rising to 101.55. The equivalent-maturity Treasury yield slid six basis points to 1.91 percent. The 2 percent note gained 18/32 to 100 14/32.
Greece’s economy, in its fifth year of recession, will contract 4.4 percent in 2012, according to European Commission forecasts on Feb. 23. The second bailout in as many years includes a debt swap with private bondholders, who will lose 53.5 percent of their principal.
High debt levels in Italy and Spain have sent borrowing costs to euro-era highs, slowing growth. The Italian 10-year yield (GBTPGR10) rose to 7.48 percent on Nov. 9, with Spain’s reaching 6.78 percent on Nov. 17.
Italy’s gross domestic product will drop 1.3 percent this year, while Spain will contract 1 percent and Portugal 3.3 percent, according to the commission.
The euro region will shrink 0.3 percent this year, from a November estimate of 0.5 percent growth. Government debt for the 17-nation bloc will increase to 90.4 percent of GDP from 88 percent in 2011, and will climb to 90.9 percent in 2013, according to commission forecasts on Nov. 10.
“There still are a lot of risks in Europe,” Brian Smedley, a strategist in New York at Bank of America Corp., said in a telephone interview on Feb. 22. “Growth data for Portugal, and Greece especially, is just not sustainable.” Bank of America favors five-year Treasury notes, whose yield may reach 0.60 percent, down from 0.89 percent at the end of last week.
European Central Bank President Mario Draghi, who replaced Jean-Claude Trichet in November, has taken steps to stem the fallout. He cut the main refinancing rate by a quarter percentage point in each of his first two monthly meetings, to 1 percent, reversing increases earlier in the year. He also maintained the ECB’s bond-buying program and added money to the banking system by providing 523 financial institutions a record 489 billion euros in three-year loans on Dec. 21.
The central bank will probably allot 470 billion euros in a second three-year injection in two days, the median of 28 analyst estimates in a Bloomberg survey showed.
The measures have helped underpin an equity recovery, with the Stoxx Europe 600 Index (SXXP) rising 8.3 percent this year as of last week, its best performance since a 10.1 percent gain in the comparable period of 1998. The euro strengthened to the highest level since Dec. 5 on Feb. 24, reaching $1.3487. The yield on the 10-year Italian bond was at 5.39 percent today, with the Spanish yield at 4.97 percent.
Funding Costs Drop
“Draghi is the man in the right place at the right time,” Fabrizio Fiorini, the chief investment officer at Aletti Gestielle SGR SpA in Milan, which manages $8 billion, said in a Feb. 24 telephone interview. “What he has done, especially providing the long-term loan, is a game changer that defuses a lethal time bomb. Some people argue that all he did was buy time. But time is absolutely essential in solving a problem.”
The loans have helped drive the premiums that European banks pay to get dollar funding through currency swaps down from a three-year high in November, while they remain above the lows of last year.
Three-month cross currency basis swaps, which show the cost to convert euro-denominated loans into dollar debt, were 68.1 basis points below the euro interbank offered rate, or Euribor, today, cheaper than the 162.5 basis points on Nov. 30, which was the most expensive since the months after Lehman Brothers Holdings Inc. collapsed in September 2008. The premium was at about a two-year-low of minus 7.1 basis points on May 3.
Government focus on reducing debt instead of boosting growth is hurting industries even in countries without outsized deficits. Siemens AG of Germany, Royal Philips Electronics NV in the Netherlands, and at least 105 other Stoxx 600 companies have reported results that missed analysts’ forecasts since Jan. 9, Bloomberg data show.
Limoges, France-based Legrand SA (LR), the world’s largest maker of wiring devices, said Feb. 9 that its operating margin may fall this year as sales stagnate because of southern Europe’s slump. Steelmaker ThyssenKrupp AG (TKA), based in Essen, Germany, said five days later it was unable to give a “reliable” outlook given the crisis.
Social unrest may make it harder for governments to fulfill their austerity pledges. Thousands of protesters rallied across Spain on Feb. 19 against a decree that lowers the cost of dismissing workers and makes it easier for employers to reduce wages. Rioters in Athens set fire to as many as 45 buildings, including banks, shopping malls and national heritage sites during protests that began on Feb. 12.
The crisis has also cost politicians their jobs. At least five prime ministers, including Italy’s Silvio Berlusconi and Greece’s George Papandreou, have lost their positions. French President Nicolas Sarkozy has been gaining in opinion surveys, though he still trails Socialist Party opponent Francois Hollande less than two months before elections, according to CSA polling institute.
“It’s a hard environment to implement austerity measures,” Helen Roberts, who oversees 27 billion pounds ($43 billion) as head of government bonds at F&C Asset Management in London, said in a Feb. 21 interview. “The Greek government might not be able to do much even though they are fully committed to the agreement.”
While European leaders cut spending, Obama sent Congress a $3.8 trillion budget on Feb. 13. He proposed more money for jobs, highways, bridges, schools, student aid and manufacturing research, even as the deficit increases to a projected $1.33 trillion this fiscal year from $1.3 trillion in the year ended Sept. 30.
The Federal Reserve has bought $2.3 trillion of Treasury and mortgage-related bonds between 2008 and June 2011 to support the economy in two rounds of so-called quantitative easing, and has pledged to keep its target interest rate for overnight loans between banks at about zero through 2014.
The U.S. economy will expand 2.2 percent this year, according to the median of 79 forecasts compiled by Bloomberg. It will grow 2.5 percent in 2013, with the euro area returning to growth at 1 percent, separate surveys show.
“The credit markets reaction makes complete sense because the Greek deal does not solve the fundamental problems, at best it buys some time,” Michael Darda, chief market strategist at MKM Partners LP in Stamford, Connecticut, said in a telephone interview on Feb. 24. “The Fed has thus far avoided the mistake the ECB made, tightening policy when they should have been easing, which is one reason the recovery here seems to be doing a bit better.”
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