EMU Sovereign Spreads Consolidate

EMU Sovereign Spreads Consolidate, Awaiting Clarity on Spain ESM Application

By Myles Bradshaw, EVP, PIMCO

The week ending October 26 saw a market reversal and a widening in eurozone sovereign spreads to Bunds. Ten-year Spanish spreads moved almost 30 basis points (bps) wider, Italy 20 bps wider and France 10 bps wider. This consolidation in risk appetite was also reflected in credit spreads, with the iTraxx Europe main investment grade index seven bps wider. The flip side was a five-basis-point fall in 10-year Bunds on the week.

The consolidation in eurozone sovereign spreads largely reflects technical factors rather than new fundamental information. Ten-year Spanish spreads to Bunds touched six-month lows in mid-October, around 180 bps below their end of August levels. With the good news of Spain’s investment grade confirmation out of the way, and without any greater clarity on Spain’s European Stability Mechanism (ESM) application, it is not surprising that short-term traders are tempted to book profits. The result is that Spanish 10-year Bund spreads are trading back around their September lows.

What happens over the next few weeks very much depends on Spain’s ESM application. Without greater clarity on Spain’s intentions, markets may want higher risk premiums for the policy uncertainty. And higher yields will reignite the risk of rating downgrades: Both S&P and Moody’s have said that the BBB− rating assumes that Spain will apply for a precautionary ESM programme in the near future.

The coming week’s spotlight falls squarely on Greece. So far the government coalition parties have reached agreement only on the fiscal austerity measures. The smallest coalition partner, Democratic Left, continues to demand concessions on the labour market reforms. Both fiscal and labour reforms are due to be submitted to Parliament this week, concurrent with Eurogroup discussions on the Greek programme.

At this stage it is not clear if Democratic Left parliamentarians will oppose or merely absent themselves from the parliamentary vote, expected the week after. While Democratic Left may win political points for opposing the Troika, we don’t expect them to pursue a strategy that ultimately brings down the government: This would be against their instincts for political self-preservation.

The size of the government majority, with or without Democratic Left opposition, means that a major back-bench rebellion would be required for the Troika measures to fail in Parliament.

Politics is by its nature difficult to predict, but a large-scale rebellion would run counter to the narrow political self-interest of the said same parliamentarians. They are aware that a rebellion would probably bring down the government, triggering economic chaos, new elections and a sharp rise in support for extremist parties. So while it may not be popular, supporting these measures aids their own narrow political interests.