STOCKS SLIDE WHILST BONDS REACT FEEBLY IN EUROZONE’S PERIPHERY

On Friday 25th May Italian and Spanish bank stocks took a severe plunge. This slide came as a sudden acceleration of a steady downward movement that had begun a week earlier. Spain’s main index IBEX dropped by 2,4% in a day, while the Italian FTIF8300 lost 3,4% of value. It came as no surprise that German shares and bonds were the destination of the funds leaving Italy and Spain with some also flowing toward US Treasuries.

The Spanish political impasse with their prime minister facing a no-confidence vote combined with the new Italian Eurosceptic government’s monetary policy to deliver a shock to the markets. It is now obvious that an unresolved banking crisis cannot be ignored even if a country is currently running a reasonably small deficit. High levels of non-performing loans (NPLs) trouble the banks’ balances. Additionally, a period of very low or zero interest rate policy by the ECB kept alive companies that may not survive an interest rate hike and whose loans would in that case add to the bulk of NPLs. Italy and Spain are, together with France, the top three European countries when it comes to NPLs in absolute terms. Another problem for the banks introduced by an interest rate hike will likely be long-term loan refinancing. Despite the mitigation measures undertaken by the ECB, the banking sector of the Eurozone is far from healthy.

 

BONDS UNDER-REACTING

At the same time the yield on the Italian 2-year bond shot up to its highest yield in five years. The spread relative to German bonds reached its widest gap in four years. A week ago it still traded at negative yields. One might expect that a proposal of such drastic measures as issuing an alternative currency would reflect more strongly on the Italian bonds, for the yield settled around 2%. The negative interest yield was made possible by the ECB undertaking its own quantitative easing, buying government and corporate bonds in large quantities, effectively disabling the markets’ proper price discovery. Institutions obliged to buy these bonds paid a price for the ECB’s measures.

However, rising turmoil and uncertainty in the Italian political sphere may also cause rising bond spreads in the days to come as the Italian president vetoes the new government’s choice for the minister of finance. New elections are not excluded as tensions and uncertainty grow.

 

THE EURO –  A CURRENCY AT RISK?

The Italian government with a history of competitive currency devaluations has been without this monetary measure since the adoption of euro. Without the devaluation option they can try to bring down costs, an option usually hugely unpopular with the population. This is why the new coalition government has proposed a parallel currency acting as short-term IOUs and a debt write-off to lessen the country’s gargantuan debt. The question is would they be prepared to go as far as pulling out of the Eurozone? This is a thought that might keep many investors on their toes. Or will we see a reiteration of the Greek story with the government making a U-turn after negotiations in Brussels?

The Euro remains a currency of one monetary policy coupled with different fiscal policies in different countries which makes it unique and not totally unlike the gold standard. Tensions within the Eurozone imbue the euro with risk that no other major currency has. The flip side of the risk mitigation policies are the negative yield bonds of the countries with massive deficits and an underperforming banking sector. With prolonged periods of negative yield we could expect institutional investors such as pension funds and life insurers, traditional bond buyers, to start turning to other instruments such as corporate bond ETFs.

David Prezelj
David Prezelj

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