Spanish Bonds Decouple from Portugal

There have been two main surprises this year. The first is how the jasmine revolutions in MENA. It is one thing to recognize the fragility of those ancient regimes, it is another thing to watch a number of government's collapse. The second is that the European debt crisis seems to be having a marginal influence at best on the global capital markets. We had thought this was going to be the main driver at the start of this year.

The debt crisis appears to have been trumped by monetary policy. Starting with the first ECB meeting of the year, officials have sounded particularly hawkish and this of course culminated with last week's ECB meeting at which Trichet used some word plays to signal the intent to raise interest rates very soon. The use of "strong vigilance" and the failure to say that "rates are appropriate" were understood by market participants as they were intended.

At the same time there appears to be shift in the way the market sees the European debt crisis. Specifically, the investors seem to have confidence that a firewall has been built around Spain. As the Bloomberg chart attached shows, Spanish bonds have become decoupled from Portuguese bonds. The chart looks at a 60-day rolling correlation between Spanish and Portuguese bonds. What had been a strong positive correlation is now negative. From the revelation of deception by the Greek government in late 2009 through the H1 2010, the correlation was mostly between 0.6 and 0.9. In August and September 2010, as some investment banks were encouraging investors to move back into peripheral bonds, the correlation between Spain and Portugal bonds broke down and in October dipped into negative territory. However, as German's Merkel floating the idea of burden sharing and the Irish crisis became more acute, the correlation jumped back to 0.80.

It has been trending lower and was briefly inverted in late January, but staged a small recovery (to about 0.2). It has collapsed in early March and finished last week near -0.31. Even if Portugal receives aid, as the market seems to be assuming, it would not necessarily adversely impact Spain.

One of our key points has been that the recipient of aid is not being bailed out, but rather the creditors are being kept whole. Spain is an important creditor of Portugal. A catalyst for new pressure on Spain comes from its handling of its banking challenges and the risk of restructuring of others in the periphery, which we continue to suspect will ultimately be necessary.