Markets

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

Tough times lie ahead for Portuguese bonds.

They were a euro area laggard last year, and 2017's looking pretty poor. European Stability Mechanism Managing Director Klaus Regling said last week markets are “nervous” about Portugal’s debt level, financial sector and competitiveness.

Europe's Steepest Yield Curve
A return by Portuguese debt to crisis-era levels could see the curve invert
Source: Bloomberg
Dotted lines indicate lack of issuance at that part of the curve

Portuguese yields had got low enough to suggest we were a long way from the bailout days of 2011-2014. While it's been a bad few months for bonds around the world, Portugal's are showing particular strain. Recent developments justify concern about Portugal's ability to depend on support from the Troika of the European Central Bank, European Commission and the International Monetary Fund.  

The government is doing itself no favors by straying from the austerity path. Portugal was the poster child for fiscal tightening during its three-year stint in intensive care, under the previous center-right government. The hard work paid off, as seen in the plunge in bond yields.

The Winter of Discontent
Portuguese bonds have widened 150bps to Germany since the summer
Source: Bloomberg

However, the current Socialist-led minority coalition under Prime Minister Antonio Costa has reversed cuts in public sector salaries and pensions, and progress in stabilizing the government finances has stalled. The finance ministry has been at pains to point out that the 2016 deficit to GDP ratio beat its 2.5 percent target. However, there has been next to no progress in reducing the debt to GDP ratio, Europe's third highest after Greece and Italy. That is a fundamental problem that will never be resolved unless there is a debt writeoff -- which unfortunately would only be over Germany’s dead body.

Trapped in its 232 billion euro ($248.2 billion) debt vortex, what has kept Portugal out of trouble is its adherence to the Troika’s demands for fiscal discipline. Its economy is one of the smallest in the euro zone, so the government just doesn't have scope to threaten officials with recalcitrance, as Italy can. While the ESM has plenty of funds to underwrite Portugal’s debt it would balk at allowing it to slip back into emergency measures. 

Flatlining
There's been little improvement lately for Portugal's debt to GDP ratio, and not much in sight
Source: IGCP

The timing could not be worse as Portugal has bumped up against the ceiling of the ECB’s 33 percent issue and issuer limits for its Public Sector Purchasing Program. Ireland is in the same boat, as Gadfly's pointed out. Central bank purchases have been crucial in driving down Portugal’s bond yields, but instead of the 1.4 billion euro monthly pace that's allowed by program rules, this has dropped to 700 million euros in December and will likely fall further to a 440 million-euro pace. Portugal’s support mechanism is being taken away from it while it very much still needs all the help it can get.

Though it's taken the short-term step of issuing a benchmark 10-year bond, at rather a punchy yield, to keep the purchases flowing, this isn't a sustainable solution. 

Fitch Ratings is due to review its BB+ credit rating for Portugal on Feb. 3rd, and has warned that it has concerns about the government's balance sheet and banking system. Its outlook is stable, but even a move to negative would be a big sign that the direction of travel has changed, and heap pressure on the importance of its sole investment-grade rating from the Canadian agency Dominion Bond Ratings Service Ltd. at BBB (low). That rating is vital for Portugal to retain access to the ECB’s QE -- becoming ineligible would plunge its bonds back into crisis territory.

Rules can be amended but it would require some creative moves yet again from the ECB, the Eurogroup and crucially its own government to not see Portugal debt spiral out of control.

Portugal's been posting middling rates of economic growth lately, and it has a decent amount of liquidity. But indebtedness is very high, and it looks like officials have lost the appetite to bring it under control and keep the troika onside. Investors look like they're starting to catch on to this shift, and that could worsen down the road. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net