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Friday, 25 July 2014

The mispricing of Spain: the Draghi Put sees investors lose sight of fundamentals

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Would the dramatic improvement in sentiment towards the eurozone have come about had it not been for the sharp fall in the government bond yields of Spain, the focal point for market anxiety last year? Put another way, is the suppression of Spanish sovereign risk by the ECB’s bond-buying programme responsible for much of the recent rally in European credit markets?

Nicholas Spiro

Nicholas Spiro, Managing Director of Spiro Sovereign Strategy

Unfortunately, we believe it is. What’s more, we believe price action in Spain’s bond market has become increasingly detached from fundamentals, questioning both the sustainability of the rally and investors’ perceptions of the eurozone as a whole. Having been somewhat paranoid about Spanish risk as recently as last July, markets have now become dangerously complacent. This is not what the ECB intended when it unveiled its Outright Monetary Transactions programme in September and raises the question of whether Spanish – and to a lesser extent Italian – risk is being mispriced.

The signalling effect alone of the OMT scheme has caused the yield on Spanish two-year paper, the most recent proxy for nervousness about the eurozone, to plummet by some 400bp since July 26 (the day ECB president Mario Draghi pledged to do “whatever it takes” to shore up the eurozone). Even the yield on Spanish 10-year debt, which is not even covered by the OMT programme, has fallen by 260bp to 5%, some 40bp below its level in April 2011 when commentators were claiming Spain had “decoupled” from the rest of the periphery.

…for the bond market rally in Spain to endure, investors’ faith in the ECB’s readiness to prop up Spain’s debt market must continue to outweigh the significant and, in some cases, increasing idiosyncratic risks in Spain.

So pronounced is the improvement in sentiment towards Spain – the Treasury’s first batch of debt auctions this year have been well received, with decent demand and a further drop in yields – that Madrid is now mulling a syndicated 10-year bond sale, following in the footsteps of Italy whose new 15-year syndicated issue on January 15 attracted strong demand from yield-hungry foreign investors. Make no mistake about it, Spain’s bond market is on a roll.

Pure liquidity

Yet foreign investors are not returning to Spain and Italy because of the countries’ improved fundamentals. Far from it. This is a purely liquidity-driven rally in which investors are banking on further yield compression. In the most conspicuous example of how the ECB’s bond-buying programme is changing the credit landscape in Europe, an increasing number of prominent bond investors are once again treating Spain and Italy as “convergence trades” – an investment strategy that was almost unthinkable only several months ago and elicits an ominous sense of deja vu.

By removing the immediate threat of a catastrophic break-up of the eurozone, the ECB has made Spanish and Italian debt more appealing to investors who, although still mindful of Spain’s underlying problems, see limited downside risks what with the liquidity backstop in place. This suggests that market thinking with regards to the eurozone periphery remains binary: the fact that the worst-case scenario has been averted is itself an opportunity to add exposure.

Yet for the bond market rally in Spain to endure, investors’ faith in the ECB’s readiness to prop up Spain’s debt market must continue to outweigh the significant and, in some cases, increasing idiosyncratic risks in Spain. It stands to reason that these risks cannot be suppressed indefinitely by the signalling effect alone of the OMT programme. At some point, something is going to have to give in view of the severity of Spain’s fiscal, economic, banking, political and, potentially, constitutional woes.

Still, the rally has already lasted much longer than many anticipated and, in our view, is likely to persist for some time yet mainly because, in the absence of systemic risk in the eurozone, investors have become much less sensitive to country-specific risk – one of the main reasons behind the high level of complacency in the markets right now.

The mispricing of sovereign debt in the eurozone is a familiar tale. Only this time round, the break-up genie has been out of the eurozone bottle for some time despite the ECB’s evident success over the past several months in reducing “convertibility risk”. Any number of possible triggers, more likely external as opposed to domestic, could refocus attention on the unresolved faultlines in Europe’s shaky monetary union and put renewed pressure on Spanish spreads. 

The OMT programme, it has now become clear, came with a hefty price: complacency among policymakers and investors alike. Spain is a perfect example of this.

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Dr Nicholas Spiro is managing director of London-based Spiro Sovereign Strategy, a niche consultancy specialising in European sovereign credit.  Dr Spiro advises private and institutional clients on the more qualitative and idiosyncratic determinants of sovereign risk, with a particular focus on southern Europe and emerging Europe.

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