The ECB's Fading Firepower

So Long, Year of the Bond-Market Rooster

Portugal's jaw-dropping yield performance may hit an ECB wall.
Photo by DeAgostini/Getty Images

For European government bond markets, QE is staggering through its finale. Some borrowers will have a tougher time dealing with the end of days.

Gadfly has already written how pressure is building on the European Central Bank to break the habit of a lifetime and keep its pledge to stop quantitative easing in September. Its resolve to do this may get a boost next week, when officials publish new economic projections alongside their policy decision. A rosier outlook can only bolster the case for curtailing stimulus.

The trick now is to figure out where the worst of the damage in fixed income will land. Negative bond yields look to be the weakest link. On top of that, the premium of the weaker economies in Europe to Germany has shrunk too far given their fundamentals.

Below Zero

Most European government bonds out to two years yield below the -0.40% ECB deposit rate

Source: Bloomberg

From this perspective, the most at-risk are Italy and Portugal which have the fourth- and fifth-highest debt to gross domestic product ratios in the world. Yet both of their yield curves are negative out to four years. 

Italy's economic growth has been pretty sluggish compared to the rest of the region's big economies, its banking system is still overwhelmed with bad debts and you'd never guess it has an election coming up in early 2018. Careful bond-market observers will have remembered that the run-up to France's general election earlier this year produced rather a lot of volatility in the nation's bond markets.

The ECB seems to have worked its magic on the world's fourth-biggest bond market, because so far Italy seems to be immune. It's hard to see how that can last, and it's not just because of the unbelievable reemergence of Silvio Berlusconi. The growing influence of the center-right could signal a change in government, which is not conducive to stability. 

But it is the much smaller, though only marginally-less indebted, Portugal, that has benefited the most from the QE program. The Iberian peripheral has been the star of the European government bond market this year, with spreads to Germany narrowing by far the most of any euro area nation.  Portuguese 10-year yields are now 1.9 percent. That is some journey from a peak of over 16 percent in early 2012, and is more than a little puzzling given that, improvement in its fundamentals has been glacial. 

The Year Of The Rooster

Portuguese 10-year yields have more than halved despite the ECB limiting QE purchases

Source: Bloomberg

The Portuguese national animal is a colorful holy rooster. Galo de Barcelos.

Some of this positive sentiment is down to an optical illusion. This year the ECB may have bought about 10 billion euros ($11.9 billion) less of Portuguese debt than permitted by its pre-set limits on purchases, known as the capital key, because its QE program is already close to holding the maximum allowed. This gives the nation's bonds the appearance having some firepower in reserve -- something beyond the normal put that's supported European debt markets through all manner of strife this year. The end of quantitative easing will further dissolve this illusion. 

Even worse, it's prey to the fortunes of Italy, which is the bellwether for peripheral debt. What's been good for Italy has been fantastic for Portugal. And were a risk-off sentiment to grip Italian bond investors, Portugal would get swept along in the shift. 

Wafer Thin

There's hardly a premium for Portugal versus Italy anymore. That can't be right.

Source: Bloomberg

There's another wrinkle. ECB President Mario Draghi's term ends in 2019. Rumblings on his successor will surely lead to more fixed-income volatility, particularly if sentiment focuses on Jens Weidmann, the hawkish Bundesbank president. 

It's spectacularly unrealistic to think that in 2018 these bonds could maintain, let alone surpass, their outstanding performance of 2017. The negative yielding peripherals of Europe should take care.  

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

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    Marcus Ashworth in London at

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    Jennifer Ryan at

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