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Friday, 15 December 2017

Deja vu

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The recent divergent spread performance within Europe is the mirror image of the compression that took place in the lead up to the introduction of the common currency. Given the widening of peripheral spreads and the dramatic fall from grace of Greece, the pendulum has now swung full circle: Germany has regained the exalted status it enjoyed in the early 1990s.

The performance of European sovereign spreads was widely expected to come under scrutiny this year, although the pace at which the dislocation has occurred has surprised many market participants. The Hellenic Republic, rated A1/A-/A at the beginning of 2009, has been the main casualty of a worsening economic environment. Its escalating budget deficit eventually forced it to make recourse to an EU/IMF backed rescue package in April. By contrast, Germany has been the main beneficiary of the flight to quality trade. A number of European sovereigns have seen their spreads to Germany under pressure.

The existence of wide spread differentials between European sovereigns was the accepted norm in the years leading up to the creation of the euro, as high interest rates in a number of countries offset expected currency weakness. As the expectation of membership of the common currency club acted as a support mechanism, the accompanying fall in interest rates saw bond yields converge in what was one of the clearest market trends of the 1990s. Member states were forced to enact programmes of fiscal reform in order to comply with the entry conditions of the club, as outlined in the Maastricht Treaty in 1992.

The convergence trade between European sovereigns started in the mid-1990s when 10-year BTPs were yielding more than 600bp over Bunds and France 140bp more than Germany. Both spreads had fallen to close to parity by 1999 and thereafter, traded close to the level of Bunds, underpinned by the belief there was little difference in the credit standing of the member states. As recently as early 2007 the spread between Greece, Italy and Germany was largely defined by a range between plus 20bp-30bp. Both have since come under pressure: ten-year Greek spreads, which had traded very close to those of Italy for many years, decoupled to a peak of plus 305bp in early 2009. From this point there was steady recovery to a low at plus 109bp in the summer of 2009.

That was before the latest widening trend started, when the market concluded that a debt/GDP ratio of around 13% was unsustainable.

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