Unintended consequences of private sector participation
Last week we explored the question of “Will it be Portugal or Ireland next?” and our thoughts were that the focus was shifting to Portugal more than Ireland. The decision by Moody’s to cut Portugal’s credit rating to sub-investment grade will help to promote an even greater divergence. Portugal debt will move toward trading closer to Greece than Ireland as markets focus on early restructuring risks. Contagion risks remain in play and this while new highs on Spanish 10-year spread is to be expected the more important is a likely breach of 6.00% on a yield basis.
Our concern related to the second bailout for Greece and the impact of private sector involvement. Specifically we said that given the ’voluntary’ nature of private sector participation for Greece, which is currently being worked out, it would make sense for banks/financials to rush for the exit now on Portugal and Ireland. Indeed for investors in general next time things might be a little less ’voluntary’ and less focused on banks/financials. What we found interesting was that over the last few weeks bid/offer spreads on Ireland and Portugal failed to come in, with the 10-year yield on Portugal moving above Ireland (using mids) suggesting that the pressure was shifting to Portugal.
Moody’s rating action will help to promote increased divergence especially as Ireland seems to be showing that it has been able to stick to the fiscal script. What was interesting in Moody’s rationale for downgrading Portugal is that it was related to the ’voluntary’ involvement of private investors in the Greek bailout which does not help Portugal return to the capital markets. Moody’s says that “EU’s evolving approach to providing official support” implies future lending to Portugal will involve private sector participation and this 1) increases the economic risks facing current investors and 2) discourages new private sector lending going forward.
While we will see Portugal trade further away from Ireland and more toward Greece in the coming weeks we must keep in mind that Ireland also faces difficulty in returning to the market. A downgrade for Ireland on the basis of not being able to return to the market should thus in theory be around the corner. Continued pressure on Portugal and Ireland will also mean more in the way of pressure on Spanish bonds where a break of 6.00% now seems likely over the coming weeks. EUR/CHF returning back below 1.20 and breaking its low just below 1.18 should also be expected as the relief rally gives way to a resumption of CHF safe haven flows.