Thoughts Ahead of Spanish and Italian Bond Auctions

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Spain and Italy begin this year's funding operations with bond auctions tomorrow and Friday. Although the euro is bouncing along its recent trough against not only the dollar, but against many of the other major currencies as well, there has been a modest improvement in some of the measures the market has focused on as metric of stress.

The 3-month cross currency basis swap, which is what banks pay to swap euros into dollars is at it lowest level in three months and the Euribor-ois swap is the lowest in almost two months. Three-month LIBOR itself has not risen since Jan 3. Although the decline has been very small, it has been rising nearly non-stop since the end of last July.

Of course there are other signs that still show a high level of paralysis, including the fact that overnight deposits at the ECB continue to set record levels and are approaching 500 bln euros.

Since the turn of the year, European banks have issued an estimated 15 bln euros of senior unsecured bonds, which is a little more than issued in the entire second half of last year. Banks have issued almost the same amount of covered bonds, matching last month's issuance in the first ten days of January.

European banks face at least 800 bln euros of maturing debt this year. The market's focus turns squarely to the sovereign issuance with this week's sales by Spain and Italy. On one hand, Fitch's comments yesterday, suggesting more than one notch downgrades of both countries is possible before the end of the month cannot be helpful, even if most market participants generally anticipate this eventuality. On the other hand, the sovereign maturing bonds and interest payments just about covers the anticipated sovereign bond supply this month.

The problem of course is that under the conditions of EMU, proceeds freed up from one maturing issue does not have to be reinvested in that country nor the currency necessarily sold. This, coupled with the crisis conditions, drives attention toward interest rate differentials.

The premium that Italy and Spain pay over Germany has widened considerable over the course of the crisis. With the credit concerns, many intuitively will understand why investors would demand a higher yield to buy Italian and Spanish paper. Yet, what has actually happened may be surprising.

We consider the 2-year bonds first. On the eve of the onset of the crisis, the end of H1 07, Italy was paying about 8 bp more than Germany. Now it is paying more than 460 bp more than Germany. However, the vast majority of the widening can be accounted for not by the increase in Italian yields, but rather the decline in German yields. Italian 2-year yields have risen 24 bp, but German 2-year yields have fallen more than 430 bp.

In Spain, this observation is even more true. At the end of H1 07, Spain was paying 4 bp more than Germany to borrow for 2-years. Now it pays about 288 bp more, but its 2-year yield has fallen almost 150 bp. Germany's as we noted fell 430 bp.

The longer end of the curve is more complicated but the general observation here holds: the widening of the interest rate differential--the increase in the premium Italy and Spain pays over Germany--has been more a function of a decline German rates than an increase in their rates.

Since the start of the crisis, Italian 10-year yields have risen roughly 200 bp and Spanish 10-year yields have risen about 160 bp. The German 10-year yield has fallen about 270 bp.

A more rigorous analysis would also integrate changes in inflation to get a better appreciation of the change in the real yields. Germany's headline CPI, for example, has fallen from 3.1% in 2007 to 2.1% last year. Part of the decline in nominal yields can be accounted for by the drop in inflation. Spain's inflation has fallen from 4.2% in 2007 to 2.4% in 2011. This suggests the rise in Spanish real yields is greater than the nominal rise would indicate.

Italy's CPI has actually risen to 3.3% last year from 2.6% in 2007. Italian real rates have risen, though this exercise would suggest that the increase is not as much as in Spain.

The implication of this analysis is that current spreads speak to a significant a case of a German overshoot than an undershoot by Spain and Italy. There are elements now that are reminiscent of the ERM crisis of the early 1990s when the German policy overshoot (loose fiscal policy tight monetary policy in the aftermath of the leveraged buy out of East Germany).

Although there is some talk of Germany easing the language of the fiscal brake, and Germany did cut some taxes last year, a sustainable resolution of the European crisis will likely require a greater policy adjustment from Germany, not just additional austerity from countries like Spain and Italy.