Thursday, May 3, 2012

The end of austerity?

At first glance, the Eurozone debt crisis still seems to be the pre-dominant driver of financial market dynamics: Bund yields are reaching new record lows almost on a daily basis while spreads of peripheral bonds trade at wide levels. However, while fears concerning a Spanish debt explosion were the key driver behind market dynamics up to mid April, amid rising expectations of more monetary easing and most importantly an end to austerity, the focus has no shifted towards a general Eurozone recession with different implications for the markets.

The chart below shows the level of 10y Bund yields together with the 10y Spain-Bund and 10y Italy-Bund spreads. As can be seen 10y Bund yields started to fall around mid March, just as Italian and Spanish spreads to Bunds started to widen again, following the ECB-LTRO induced easing of tensions at the start of the year. Between mid March and mid April peripheral bond spreads to Bunds widened sharply. This was the period where fears about the crisis in Spain intensified (recession, imploding housing bubble, uncertainty about the recapitalisation needs of the banking sector etc.) and also fears regarding a potential rating downgrade of France (not least due to a potential change in the presidency) intensified. However, from mid April onwards peripheral spreads stopped widening and moved into a range-trading environment while Bund yields continued to fall.

10y Bund yields and 10y BTP/BONO spread to Bunds

Source: Bloomberg

A very important implication is that prices for peripheral bonds are falling again (lower Bund yields + stable spreads = lower peripheral bond yields) which is a very welcome development. But why are yields now suddenly falling across the Eurozone government bond universe? I think the reason is twofold: a) rising speculation concerning a potential ECB rate cut and b) waning political support for austerity/rising political support for growth enhancing measures.
Given a deposit rate of 0,25% and the high amount of excess liquidity, EONIA has settled in the low 30bp area and should be expected to remain there as long as neither the deposit rate nor the amount of excess liquidity changes. However, in mid-March EONIA Forwards (I used the 9x12M. EONIA Forward in the chart below) have started to price in a tightening of monetary conditions some months down the road and moved significantly higher (assuming a lower level of excess liquidity or a higher deposit rate). This potentially was also a key driver behind the peripheral bond spread widening which started at the same time. Amid the wave of very weak economic data out of the Eurozone which are increasingly painting a recessionary picture, around mid-April EONIA forwards started to discount a lower level of EONIA than warranted by the current monetary stance (so starting to price a depo rate cut/higher level of excess liquidity). Hence, expectations of an easier monetary policy stance are supporting asset prices in general.

9x12m OIS have started to price further monetary accommodation
Source: Bloomberg

Also supporting peripheral bond prices is the waning support for further austerity measures. The negative feedback loop (weak growth = higher deficit = more austerity = weaker growth) threatens to lead more economies into an environment of everlasting recession and with that rising debt-GDP ratio (as GDP shrinks), rising risk of social unrest and waning support for the Euro. However, the political consensus for further austerity measures seems to be a thing of the past. With a potential victory of Mr. Hollande in France who wants to renegotiate the fiscal compact and the call for early elections in the Netherlands two important allies of Germany are change sides. Rather the focus is now shifting towards growth enhancing measures via infrastructure investment and more structural reforms. Sure enough, even if these would be enacted, it would take time to support growth. But more important is that the period of further austerity measures in an environment of weak growth seems to be coming to an end. 

In sum, markets have shifted from pricing a worsening debt crisis lead by developments in Spain towards pricing in a recession in the Eurozone which, however, leads to further monetary accommodation but no more fiscal tightening. This in turn, would increase the probability of a more growth friendly environment further down the road and hence reduces the risk of a Eurozone break-up/debt-deflation spiral.
As long as the austerians do not gain the upper hand again and the prospects for more monetary easing stays alive, the stabilisation in peripheral bond markets can continue. As long as economic data continues to disappoint, Bund yields can fall further.