bonds

The ECB denies nudging Portugal towards its bail-out, but data just released suggest otherwise. Despite growing problems in the eurozone the ECB bought no government bonds last week. Buying government bonds either at auction or through the secondary market is a practice employed heavily in the past but frugally of late to suppress the cost of debt in vulnerable economies and shore up market confidence.

It also means the ECB did not buy any bonds in Portugal’s punitive bill auction last week. The prohibitive cost of debt at that auction is likely to have influenced Portuguese policymakers in seeking a bail-out. Lisbon is facing the expiry – and therefore the refinancing – of nearly €4.4bn debt in mid April and the bill auction gave an indication of the market’s likely price. 

Many investors fear that the Fed’s impending exit from QE2 will have a very damaging effect on the financial markets. Whether they are right will depend on the nature of the exit, and its impact on bond yields. An end to the Fed’s programme of bond purchases, without any increase in short rates, is unlikely to be sufficient, on its own, to trigger a major bear market in bonds and equities. But an end to the Fed’s “extended period” language on interest rates would be a much greater threat. I still do not expect this to happen soon.

Recently, the Fed has purchased 60-70 per cent of all the bonds which have been issued to finance the US budget deficit. Some influential analysts (Bill Gross of Pimco among them) argue that bond yields will rise sharply when the Fed withdraws its life support from the bond market. But there are some powerful advocates, including the Fed chairman himself, for an entirely contrary point of view. Ben Bernanke told Congress in February that he did  not expect to see “a big impact” on bond yields when the Fed ended its asset purchases.

The Fed has hardened its thinking on this question in the past couple of years. It has  decided that QE reduces bond yields via its effect on the total stock of outstanding bonds, and not via its impact on the flow of bonds purchased in any given period. If this is the case, then

 

Ralph Atkins

The eurozone debt crisis re-erupts. Bond market tensions soar over the escalating problems faced by Portugal and Ireland. But there is no sign of the European Central Bank intervention today.

Surprising? It should not be. The ECB would not want to be seen helping governments overtly, especially with a European Union summit just beginning in Brussels. Only once politicians have acted has it in the past seen the case for an appropriate ECB response.

Most famously in May last year, Jean-Claude Trichet, president, said the governing council had not even discussed bond purchases at its meeting in Lisbon. Then a day later, came the Brussels summit that drew up the original eurozone rescue package. Only afterwards did the ECB launch its purchasing programme.

Now, there are other reasons for the ECB to hold back. 

Sovereign bondholders received the worst news possible from eurozone policymakers yesterday: a dire combination of confirmation and uncertainty about the key issue of bondholder rights from the ESM term sheet, which sent yields up on all sovereign debt seen likeliest to restructure (read: Greece, Ireland and Portugal).

(Note: All that follows is subject to a rubber-stamping confirmation at meetings Thursday-Friday. It is unlikely any details will change.)

First came confirmation that the eurozone would in theory allow a member state to restructure their debt. (You’d have been forgiven for thinking eurozone bail-outs to date, such as Greece and Ireland, were specifically intended to prevent such an outcome.)

Second came confirmation – at long, long last – that sovereign bondholders will lose protection on their investments. (It is likely in practise that this means a sovereign bond will become worth less if its issuing government receives aid. It is hard to see what other forms of “involvement” – emotional support? – would be expected of bondholders.) 

European Central Bank hopes of an easy exit from government bond purchases have been dashed by the deal on the eurozone’s future, which left it the precarious task of deciding when its action to boost investor confidence can be halted for good. Jean-Claude Trichet, ECB president, lobbied hard for European Union rescue funds to be given powers to buy bonds in the open market. If he had succeeded, the ECB could have formally ended its programme, contentious since its launch, which has seen it spend €77.5bn ($108bn) since May of last year.

In the face of German resistance, eurozone leaders agreed only that EU rescue funds could buy bonds directly from distressed governments in restricted circumstances. “The ECB is not a winner in this deal,” said Gilles Moec, European economist at Deutsche Bank. 

Despite record yields, no bonds bought by the ECB settled last week – that’s two in a row for the eurozone central bank. The stock of ECB-bought bonds therefore remains at €77.5bn. Next week might be different, however, as demand for Portugal’s unexpectedly successful bond auction last week might have been driven by ECB purchases.

In future, buying government bonds at auction is a role that might pass to the eurozone’s rescue fund, the EFSF. A deal struck between eurozone heads of state over the weekend agrees that the fund can intervene in primary market (i.e. government debt auctions) in exceptional circumstances. This would not entirely replace the ECB’s role, as they have bought debt in the secondary (i.e. resale) bond market, too. Of €77.5bn ECB bond purchases, we do not know the split between primary and secondary debt – though anecdotally, secondary market purchases seem to have been bigger.

If it is approved, the nascent agreement reached in the small hours of Saturday morning will address many of the symptoms of the eurozone’s disease. Note, though, that the fundamental issue of bond haircuts was not addressed. Euro leaders’ hard work leaves them on target for what was a very tight March 24/25 deadline. Measures include:

  • Increase the effective lending capacity of the EFSF from ~ €250bn to €440bn. The Fund already had €440bn at its disposal in theory, but needed to hold back a proportion in order to issue AAA-rated debt. Discussions are ongoing on how to achieve this.
  • Give the EFSF the right, “as an exception”, to intervene in primary debt markets – though with such strict conditionality that some analysts say this will make little effective difference. The right, which will extend to EFSF successor, the ESM, is not a full substitute for the ECB’s bond-buying programme, since the ECB buys bonds in both the primary market (government auctions) and secondary market (resale of already-issued bonds).
  • Lower the rates charged by the EFSF on bail-out loans to take into account debt sustainability of recipient countries. Rates should remain above facility’s funding costs and in line with IMF pricing principles.
  • Specifically, for Greece: reduce the interest rate on rescue loans from 5.25 to 4.25 per cent and increase the average maturity of Greek bail-out loans from 4 to 7.5 years.
  • €500bn funding confirmed for the ESM, EFSF successor.
  • Further explore the idea of a financial transaction tax.

 

A look at the data on Greece and Ireland should stay the hands of policymakers keen to bail-out Portugal. If those two bail-outs were intended to reassure markets, they have failed. Clarity on bondholder rights might be a better target.

Ireland was bailed out in November. Despite knowing €85bn is on tap, markets priced Ireland’s ten year cost of debt at a record high yesterday: government bonds trading in the secondary market closed at 9.39 per cent. See green line on chart, right. (Note: this number does not affect the Irish government directly since they do not finance their loans from the resale market: it is a proxy for the rate the government would have to pay to borrow from the market at auction.) These record levels are more than a percentage point higher than levels that prompted the bail-out, and just higher than the previous record which occurred post bail-out (since yields, bizarrely, rose).

Greece was bailed out in May. But Greece’s ten year cost of debt touched a record 12.82 per cent during yesterday’s trading. Their ten year debt closed at 12.68 per cent, second only to a rough patch in January. Bail-outs are useful when there’s a temporary cashflow problem – but continued and rising market stress should tell us that something else is at play. 

Markets are showing signs of stress over Portugal following Moody’s three-notch downgrade of Greece as we approach a significant bond auction on Wednesday.

Yields on the ten-year government bond reached 7.65 per cent today – a euro lifetime high – indicating Lisbon would need to pay these sorts of levels if it tried to issue ten-year debt now. (Or Wednesday.) If it goes ahead, the auction is intended to raise €0.75-1bn. This is optimistic, however. The last two auctions raised just €1.25bn between them.

So, assuming Wednesday’s auction raises €0.75bn (optimistic), the IGCP will have raised about €2bn since the start of the year from the market in bonds. Rumour has it that the agency has about €4bn in cash. So that’s €6bn, excluding bills. So what does Lisbon’s debt management agency, the IGCP, need, and by when? The answers are sobering. 

Bad day for Portugal. S&P has cut to junk the credit ratings of four state-owned utilities, saying the country’s sovereign debt troubles could limit the timeliness or sufficiency of help on offer from the government:

Government support for distressed state-owned companies was “increasingly constrained by difficult financial conditions”. This was also reflected in the “weak access” of Portuguese banks to external funding, S&P said.