Stress and Contagion Return To Europe
by Win Thin
Greece has the worst performing bonds in the euro zone, with 10-year spreads to Germany blowing out 80 bp this week and 136 bp this month. It retakes the worst-performing mantle from Ireland, whose 10-year spreads are up 53 bp and 107 bp over those same periods. CDS prices are mirroring this move, with 5-year Greece close to 900 bp today vs. the recent low around 665 bp in mid-October. Contagion is in full force, as Greece, Portugal, and Ireland have all been in the market cross-hairs in recent days. Spain and Italy are holding up better, but spreads and CDS prices for both have also been creeping up recently.
At +904 bp over Germany, Greece 10-year spreads are nearing the high of around +965 bp from pre-EFSF days. Ireland 10-year spread around +525 bp is new record highs, while Portugal 10-year spread around +410 bp today is close to testing the September record high around +427 bp. Even Spain’s 10-year spread around +200 bp is close to the +221 bp high from June. For the most part, peripheral spreads are higher now than they were before the EFSF and the European bank stress tests and that tells us that default risk has gone up, not down, since those two big events.
As we have argued all along, problems in the periphery never went really away. It’s really just that the markets’ attention moved elsewhere, risk appetite picked up, and markets moved on. We continue to believe that Greece will have to undertake debt restructuring in the next year or two, perhaps they can hold out a little longer. Furthermore, given the upward trajectory in borrowing costs, we now believe that Portugal and Ireland will also likely have to undertake restructuring as well. The whole purpose of the EFSF was to get borrowing costs back down for the periphery. Otherwise, the debt dynamics unravel, and this is something we have seen time and again in the Emerging Markets. To us, the big question is whether Spain can avoid the same fate. Markets are not punishing Spain as much as the others, and so policy-makers have for now been able to draw a ring-fence around the weakest three. But just remember that with nominal GDP around $1.5 trln, Spain is almost twice as big as the other three combined (about $785 bln total) and so any Spain bailout would be problematic for the EU/EFSF in terms of sheer size.