Why Portugal

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The periphery bonds have generally rallied this year. Ireland's 10-year bond yield is off 138 bp and Italy's is off 179 bp, for example. The Iberian peninsula stands out as an exception. The Spanish 10-year benchmark yield is down only 4 bp and that includes today's 5 bp decline. Portugal is the real outlier. The 10-year yield is up 203 bp.



Currency in Crisis

Why Portugal? It is implementing the agreed upon reforms. That is both good news and bad news. It is good news in that is offers a contrast to Greece and make for easier relations with the Troika. It is bad news because the reform are insufficient to put Lisbon on a sustainable debt path.

Portugal was able to reduce its deficit last year to 5.9% of GDP thanks in no small measure to a one-off "trick" to transfer bank pension funds to the government's social security. The IMF estimates that this alone reduced the budget deficit by 1.9% of GDP.

Unlike Greece where the debt caused the crisis, in Portugal the crisis caused the large deficit problem. Portugal's problem, at the risk of oversimplifying, is that it did not grow in good times and contracts in bad times. The EU expects Portugal to contract this year by 3.3%, the second largest in the euro area after Greece. Portugal pays more than 1100 bp more than Germany at the 10-year sector. The premium is almost as large for the 2-year as well. The bond market may be distorted by speculation that the ECB may have broken its two week hiatus and returned to market to buy Portuguese bonds today.

The 5-year CDS is just below 1200. This is consistent with about a 75% chance of a 50% haircut. Yes, European officials say Greece is unique and so it is. Portugal is unique too though in a different way.

Meanwhile, Portuguese officials are playing down the need for further fiscal consolidation to meet the terms of the 78 bln aid package. Yet earlier today, the EU budget commissioner warned that the 2012 funding shortfall may put at risk the 5 bln euro subsidiary payment.

Given that Spain not only missed last year's deficit target, but appear to be seeking approval to miss this year's as well, Portuguese officials may think they may have some room to maneuver. The key may be the real economy. It may under-perform even the lower expectation. On Thursday, Portugal reports January industrial production and retail sales figures. While the core of Europe may seeing some signs of economic stabilization, the Iberian peninsula is not. While weak economic data tends to support a sovereign bond market, this may not be the case with Portugal.

Portugal's aid package assumes it can return to the capital markets in the second half of last year. This seems less likely with each passing day.