A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

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Macro Letter – No 128 – 17-04-2020

A Rose by Any Other Name – Corona Bonds and the Future of the Eurozone

  • A European fiscal spending package worth Euro 540bln has been agreed
  • Eurozone bonds have crashed and recovered
  • Corona Bonds have been found unnecessary
  • The issue of Eurozone backed Eurobonds will not go away

On April 9th the Eurogroup of Finance Ministers eventually agreed upon a three-pronged package to avert some of the economic impact of the Covid-19 pandemic. For financial markets this was a relief, had the Eurogroup broken up, for the second time in a week, without a deal markets would have reacted badly. The three-pronged package included health expenditure funding from the European Stability Mechanism (ESM), loans for businesses from the European Investment Bank (EIB) and further funding from the European Commission’s unemployment fund. The total package is a modest Euro 540bln, the political ramifications are much less so.

What was not agreed, despite the unprecedented circumstances surrounding the pandemic, was a collective pooling of Eurozone (EZ) resources in the form of ‘Eurobonds,’ deftly renamed ‘Corona Bonds,’ by their advocates. For the fiscally responsible countries of Northern Europe, even the current crisis was insufficient for them to contemplate underwriting the prodigal South.

The compromise, agreed last week, included the use the ESM. The ESM itself, together with the outright monetary transactions (OMT) undertaken by the ECB, were forged in the 2010/2012 Eurozone crisis. At that time the convergence of Eurozone government bond yields, which had begun long before the advent of the Euro, was unravelling as investors realised that Europe would not collectively underwrite any individual state’s obligations. The North/South divide became a chasm, with Greek, Portuguese, Italian and Spanish bond yields rising sharply whilst German, Dutch and Finnish yields declined. The potential default of a Eurozone government was only averted by the actions of the then President of the ECB, Mario Draghi, when he stated that the central bank would do, ‘Whatever it takes.’

Once again, a motley deal has been forged, recriminations will follow. Whilst lower government financing costs remain a major attraction of EZ membership for newer members of the EU, the benefit is by no means guaranteed, as this 2017 paper – Eurozone Debt Crisis and Bond Yields Convergence: Evidence from the New EU Countries – by Minoas Koukouritakis, reveals: –

Based on the empirical results, there is some clear evidence of strong monetary policy convergence for each of the Czech Republic, Lithuania and Slovakia to Germany. Alternatively, under the UIP and ex-ante relative PPP conditions, the expected inflation rate of these three countries has converged to the expected inflation rate of Germany. This is an expected result not only because Lithuania and Slovakia are already Eurozone members, but also because Germany plays a very important role in the economies of these three countries. Furthermore, the empirical results provide evidence of weak monetary policy convergence for each of Croatia and Romania to Germany. In contrast, for the remaining seven new EU countries, namely Bulgaria, Cyprus, Hungary, Latvia, Malta, Poland and Slovenia, the empirical evidence suggests yields’ divergence for each of these countries in relation to Germany. For Cyprus, Latvia and Slovenia, which as Eurozone members they have common monetary policy with Germany, the empirical evidence could probably be attributed to the increased sovereign default risk of these countries, which in turn led to large and persistent risk premia.

In summary, the empirical evidence indicates that in the context of the Eurozone debt crisis, even though Germany has established its dominance and sets the macroeconomic policies in the Eurozone, several new EU countries are unable to follow these policies. And this conclusion addresses once more the issue of core-periphery in the Eurozone and, thus, the Eurozone’s future prospects.

The past six weeks has seen a global fiscal response to the pandemic. Stock markets have declined and credit spreads in corporate bond markets have widened. In European government bonds the pattern has been similar, the migratory flight to quality saw flocks of investors head north, especially into Switzerland and Germany. The simplified chart below shows three data points;

March 9th, when German Bund yields reached their recent nadir,

March 18th, the date investors became spooked by the sheer magnitude of the fiscal response required by EZ governments: and

April 14th, the day on which Italy and Spain announced the first relaxation their lockdown restrictions: –

European Bond Spread chart March April 2020

Source: Trading Economics, Investing.com

There are several observations; firstly, even as the lockdown comes towards its end, bond yields are higher, reflecting concerns about the impact of fiscal spending on government budgets as tax receipts collapse. Secondly, German Bund yields are now lower than Swiss Confederation bonds, despite expectations that Germany may end up footing the bill for the lion’s share of government borrowing across the EZ. This may be a reflection of the lower percentage fatality rate in Germany – 2.5% versus 4.4% in Switzerland – or simply a function of the greater liquidity available in the German bond market.

A third observation concerns the higher yielding countries of Greece, Italy, Portugal and Spain. Despite a larger number of Covid-19 infections, Spanish Bonos have maintained their lower yield relative to Italian BTPs, meanwhile, Greek bonds have converged towards Italy and Portuguese bonds trade within 4bp of Spain.

Convergence, divergence and political will

This is not the first macro letter on the topic of EZ bond convergence, the chart below is taken from Macro Letter – No 10 – 25-04-2014 – The Limits Of Convergence – Eurozone Bond Yield Compression Cracks the second of eight previous articles on subject: –

European Bond Yields - 2005 - 2014 - Bloomberg

Source: Bloomberg

At that time I suggested three scenarios: –

  1. Full Banking Union and further federalisation of Europe
  2. Full Banking Union but limitation of federalisation
  3. Eurozone break-up

The EZ crisis had finally disapated but the full impact of QE had not yet been appreciated, the table below shows the yield to maturity and spread over German Bunds of the 10 year bonds of Italy, Spain, Greece and Portugal traded on 24th April 2014 (roughly six years ago): –

Spreads in April 2014

Source: Bloomberg

In April 2014 I saw the second scenario as most likely. I anticipated limited ‘Eurobond’ issuance, this has not yet come to pass, but last week’s stimulus looks like a federal bail-out by any other name. Last month, as the Covid-19 pandemic took hold, the spread between German Bunds and Spanish Bonos touched 1.54%, whilst the spread against Greek bonds reached 4.22% and Portugal, 1.75%. Only Italy fared less well, the Bund/BTP spread reached 3.15; a marked deterioration since 2014.

Conclusions and Investment Opportunities

By the time I penned Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? it was becoming clear that Italy was the focus of concern among fixed income investors. I concluded (a little too late) that: –

Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero.

The spread never returned to parity.

When I last wrote about EZ bonds, I focussed once again on Italy in Macro Letter – No 98 – 08-06-2018 – Italy and the repricing of European government debt. BTP yields had risen to a spread of 1.22% over Spanish Bonos and I expected a retracement. As the chart below reveals, BTP yields rose further before than regained composure: –

Spanish BONO vs Italian BTP 10yr Yield Spread Chart - March 31st 2020

Source: Y-Charts

Eurobonds are still not on the agenda even in a time of pandemic, therefore, Italian indebtedness remains the single greatest risk to the stability of the EZ. The convergence trade is fraught with geopolitical risk as cracks in the European Project are patched and papered over. Now is not the time for revolution, but the ongoing fiscal strain of the pandemic means the policy of issuing Eurobonds backed by a European guarantor will not go away. I expect EZ government bond yield compression accompanied by occasional violent reversals to become the pattern during the next few years, together with increasing political tension between European countries north and south.

Italy and the repricing of European government debt

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Macro Letter – No 98 – 08-06-2018

Italy and the repricing of European government debt

  • The yield spread between 10yr BTPs and Bunds widened 114bp in May
  • Populist and anti-EU politics were the catalyst for this repricing of risk
  • Spain, Portugal and Greece all saw yields increase as Bund yields declined
  • The ECB policy of OMT should help to avoid a repeat of 2011/2012

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets. I will freely admit that this has led me to make a number of investment mistakes, although these have generally been sins of omission rather than actual investment losses. The Italian political situation and the sharp rise in Italian bond yields it precipitated, last week, is, therefore, some justification for an investor like myself, one who has not held any fixed income securities since 2010.

An excellent overview of the Italian political situation is contained in the latest essay from John Mauldin of  Mauldin Economics – From the Front Line – The Italian Trigger:-

Italy had been without a government since its March 4 election, which yielded a hung parliament with no party or coalition holding a majority. The Five Star Movement and Lega Nord finally reached a deal, to most everyone’s surprise since those two parties, while both broadly populist, have some big differences. Nonetheless, they found enough common ground to propose a cabinet to President Sergio Mattarella.

Italian presidents are generally seen as rubberstamp figureheads. They really aren’t supposed to insert themselves into the process. Yet Mattarella unexpectedly rejected the coalition’s proposed finance minister, 81-year-old economist Paolo Savona, on the grounds Savona had previously opposed Italy’s eurozone membership. This enraged Five Star and Lega Nord, who then ended their plans to form a government and threatened to impeach Mattarella.

The whole article is well worth reading and goes on to look at debt from a global perspective. John anticipates what he calls, ‘The Great Reset,’ when the reckoning for the excessive levels of debt arrives.

Returning to the repricing of Eurozone (EZ) debt last month, those readers who have followed my market commentaries since the 1990’s, might recall an article I penned about the convergence of European government bond yields in the period preceding the introduction of the Euro. At that juncture (1998) excepting Greece, every bond market, whose government was about to adopt the Euro, was trading at a narrower credit spread to 10yr German bunds than the yield differential between the highest and lowest credit in the US municipal bond market. The widest differential in the muni-market at that time was 110bp. It was between Alabama and California – remember this was prior to the bursting of the Tech bubble.

In my article I warned about the risk of a significant repricing of European credit spreads once the honeymoon period of the single currency had ended. I had to wait more than a decade, but in 2010/2011 it looked as if I might be vindicated – this column is not entitled In the Long Run without just cause – then what one might dub the Madness of Crowds of Central Bankers intervened, saved the EZ and consigned my cautionary oracles, on the perils of the quest for yield, to the dustbin of history.

In the intervening period, since 2011, I have watched European yields inexorably converge and absolute yields turn negative, in several EZ countries, with a temerity which smacks of permanence. I have also arrived at a new conclusion about the limits of credit risk within a currency union: that they are governed by fiat in much the same manner as currencies. As long as the market believes that Mr Draghi will do, ‘…whatever it takes,’ investors will be enticed by relatively small yield enhancements.

Let me elaborate on this newly-minted theory by way of an example. Back in March 2012, Greek 10yr yields reached 41.77% at that moment German 10yr yields were a mere 2.08%. The risk of contagion was steadily growing, as other peripheral EZ bond markets declined. Greece, in and of itself, was and remains, a small percentage of EZ GDP, but, as Portuguese and Spanish bonds began to follow the lead of Greece, the fear at the ECB – and even at the Bundesbank – was that Italy might succumb to contagion. Due to its size, the Italian bond market, was then, and remains today, the elephant in the room.

During the course of last month, European bond markets diverged. The table below shows the change in 10yr yields between 1st and 31st May:-

EZ 10yr yield change May 2018

Source: Investing.com

A certain degree of contagion is evident, although the PIGS have lost an ‘I’ as Irish Gilts have escaped the pejorative acronym.

At the peaks of the previous crisis, Irish 10yr Gilts made a yield high of 14.61% in July 2011, at which point their spread versus 10yr Bunds was 11.34%. When Italy entered her own period of distress, in November of that year, the highest 10yr BTP yield recorded was 7.51% and the spread over Germany reached 5.13%. By the time Greek 10yr yields reached their zenith, in March 2012, German yields were already lower and Irish and Italian spreads had begun to narrow.

During the course of last month the interest rate differential between 10yr Bunds and their Irish, Greek and Italian counterparts widened by 41, 100 and 114bp respectively. Italian 10yr yields closed at 4.25% over Bunds, less than 100bp from their 2011 crisis highs. With absolute yields significantly lower today (German 10yr yields were 2.38% in November 2011 they ended May 2018 at 36bp) the absolute percentage return differential is even higher than during the 2011 period. At 2.72% BTPs offer a return which is 7.5 times greater than 10yr Bunds. Back in 2011 the 7.51% yield was a little over three times the return available from 10yr Bunds.

I am forced to believe the reaction of the BTP market has been excessive and that spreads will narrow during the next few months. If I am incorrect in my expectation, it will fall to Mr Draghi to intervene. The Outright Monetary Transactions – OMT – policy of the ECB allows it to purchase a basket of European government bonds on a GDP weighted basis. If another crisis appears immanent they could adjust this policy to duration weight their purchases. It would then permit them to buy a larger proportion of the higher yielding, higher coupon bonds of the southern periphery. There would, no doubt, be complaints from those countries that practice greater fiscal rectitude, but the policy shift could be justified on investment grounds. If the default risk of all members of the EZ is equal due to the political will of the European Commission, then it makes sense from an investment perspective for the ECB to purchase higher yielding bonds if they have the same credit risk. A new incarnation of the Draghi Put could be implemented without too many objections from Frankfurt.

Conclusions and investment opportunities

I doubt we will see a repeat of the 2011/2012 period. Lightening seldom strikes twice in the same way. The ECB will continue with its QE programme and this will ensure that EZ government bond yields remain at artificially low levels for the foreseeable future.

Unusually, I have an actionable trade idea: caveat emptor! I believe the recent widening of the 10yr Italian BTP/Spanish Bonos spread has been excessive. If there is bond market contagion, as a result of the political situation in Italy, Bonos yields may have difficulty defying gravity. If the Italian political environment should improve, the over-sold BTP market should rebound. If the ECB are forced to act to avert a new EZ crisis by increasing OMT or implementing a duration weighted approach to QE, Italy should benefit more than Spain until the yield differential narrows.