When Irish Eyes are Smiling

In January, Moody's bestowed investment grade status on Ireland. It is the first of the crisis-wracked countries who regained this coveted status from Moody's which allows for wider participation in its bond market.

Moody's will review Ireland at the end of this week and there is a reasonably good chance that it revised its rating higher again. Moody's Baa3 rating is equivalent to BBB-, which lags behind both S&P and Fitch which as Ireland as a BBB+ credit. BBH's sovereign rating model suggests Ireland is really a A- credit.

It is possible Moody's upgrades Ireland by two notches, but typically as recoveries are slower than the downside of a credit cycle, rating agencies tend not to upgrade by two steps. However, our point is that the direction and is there.

Ireland's 10-year bond yield fell below the similar UK yield last week and the UK premium has risen another 3 bp today to eight basis points. Despite some profit-taking in other peripheral bond markets as the euro weakened after Draghi's comments, holding out the strong possibility of action at the June ECB meeting, Irish bonds held in best. The 10-year yield finished last week at what appears to be a record low yield of 2.65%.

Ireland boasts among the strongest composite PMI readings in the area at 60.8. The time series is short and only go back to mid-2011, but the composite PMI is the highest on record. Although the financial sector has not fully healed, the economy is regaining its (Celtic) tiger moniker. In March, the most recent data available, shows industrial output up a little more than 10% from a year ago. Retail sales in March were up almost 9% over the year.

It has been able to achieve this economic performance without generating much price pressures. Using the harmonized methodology, Ireland's April CPI stood at 0.4% year-over-year. Ireland's most recent inflation peak was in August 2012 at 2.6%. While inflation has fallen 220 bp, the 10-year yield is off about 140 bp. This leaves the simply real rate (nominal yield minus current inflation) actually higher now than a couple of years ago.

We look for further profit-taking on the European peripheral bond markets in the coming days. The technical tone has deteriorated. We see modest risk that both the April inflation and Q1 GDP figures for the euro area due later this week are reported on the high side of expectations. We also suggest that US economic data and technical considerations also favor higher Treasury yields, which could also add to the corrective pressures in the peripheral bond markets, including Ireland.