EU PERIPHERY HOLDS WHILE CENTRE FALLS APART / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

May 21, 2015 5:44 am

EU periphery holds while centre falls apart

Ralph Atkins in London

QE has induced volatility in German bonds and relative calm elsewhere

©AFP Because of high fees, the average investor does not see the fruits of managers' stockpicking labours

 

 

Quantitative easing turns the world upside down. That is certainly true in Europe. When the eurozone debt crisis was at its most intense, borrowing costs rocketed for countries such as Spain, Italy, Ireland and Portugal. In the recent bond market sell-off, however, eurozone “periphery” countries’ bonds have been remarkably stable — excluding Greece’s, of course.

 

Instead the action has been in supposedly dull German Bunds. Yields on German debt, which move inversely with prices, first plunged to near zero, then moved abruptly higher. They remain modest; 10-year Bunds yield about 0.6 per cent. But small moves inflict significant pain when the starting point is so low. Previously, Bunds provided “risk-free returns”. Now they offer “return-free risk”, quips Trevor Greetham at Royal London.

 

By contrast, the “spread” — or difference — between Italian or Spanish 10-year bonds over German equivalents has varied surprisingly little since January’s launch of the European Central Bank’s €60bn-a-month asset purchase programme. During the latest sell-off, they have tightened.

 

The relative stability is a relief for the periphery countries but highlights how QE is producing unlikely effects and anomalies that defy easy explanation. That makes its impact harder to predict: the risk is of upsets that undermine ECB efforts to boost economic growth and inflation.

Official concerns about QE-induced volatility in German markets were apparent this week in comments by Benoît Cœuré, ECB executive board member. The reversal in Bund prices was not a cause for concern; “it is the rapidity of the reversal that worries me more”, he said.

 

Against that backdrop, the ECB would take a summer holiday, scaling back its asset purchases from mid-July to August when market liquidity is typically thin and Europeans head for southern “periphery” countries’ beaches.

His comments perhaps added to the bafflement among investors — especially those comparing the ECB’s programme with QE by the US Federal Reserve. While the Fed set out in advance exactly what it would buy and when, the ECB is only announcing what it has bought after the event.

That has given it the flexibility to adjust to market conditions — such as the summer lull, but arguably it has created more volatility as a result. Market confidence in ECB communication was not helped by Mr Cœuré’s comments being delivered at a London evening event attended by investors but published only the following morning.

A main reason why QE is creating such turbulence in the Bund market is an imbalance between supply and demand: the ECB is buying large chunks of German debt when Berlin’s fiscal prudence means net issuance is negative. Expectations of aggressive ECB bidding to achieve its buying targets sent Bund prices sharply higher and yields lower. Much of the recent reversal has been about the shaking out of overcrowded investor positions.

 

 

 

The story has been different for periphery bonds. While Bund yields were tumbling, falls in periphery bond yields were more modest. One reason was that governments used the favourable conditions to increase supply. Another reason was concern about Greece: fears of Athens blowing up Europe’s monetary union resulted in investors demanding higher yields on countries that might be next in line — although the effects were modest.

 

Having fallen less, the subsequent rise in periphery yields was also limited. But there is also a positive reason why periphery “spreads” over Bunds have narrowed lately. A clear pickup in economic growth and optimism that the eurozone has averted a deflationary slump has made the debt trajectories less worrying — and justified tighter spreads.

Ireland’s turnround has particularly impressed investors and it has pulled away from the periphery pack. Spain might have behaved similarly given the recent strength of its economy, but investors remain wary of political movements such as the anti-establishment Podemos party.

 

Can the periphery’s relative stability last? Nobody makes predictions with any confidence these days. Net supply of eurozone government bonds is positive this month and in June, but turns negative in July. That could force prices higher again, and yields down. On the other hand, Greece could turn dangerous. Its ripple effects have been hard to disentangle recently — but could yet turn the world upside down again.