Why I may be wrong on Portugal because of the Cyprus deposit grab

Portugal is going to market with a 10-year sovereign bond issue, its first since 2011. I think this is a pretty big deal. Think of it as a complete return to public market access for the Portuguese government, one of the critical pre-conditions for an OMT-style bailout. This is a Herculean achievement by the Portuguese that I did not believe the Portuguese could pull off just three months ago. Ironically, I would credit the deposit tax in Cyprus for this turn of fortune. I will explain why below.

The first thing to note is what I was saying in January and February. On the horrendous numbers coming out of Europe back then, I wrote the following:

“In terms of the periphery, Spain and Portugal are the countries to watch. Let’s look at Portugal first. As El Pais reported earlier today, Portuguese unemployment has hit a post-euro high of 16.9% on the back of an accelerating contraction in the economy. Youth unemployment is now 40%. The austerity in Portugal is accelerating the decline in economic output. In Q4 the quarterly contraction hit 1.8%, up substantially from Q3′s 0.9%. Yet, the latest information is that even the IMF, which elsewhere has talked about back loading its austerity regime, is still committed to front-loaded austerity in Portugal. They have told the Portuguese that the most draconian budget in Portuguese democratic history won’t be enough. They want more cuts in 2013. Ostensibly, the reasoning here is that with Ireland on the verge of OMT status, Portugal needs to get there too and they cannot do so based on the present numbers. So, despite the hardship that front-loading austerity represents, the IMF is doubling down on this strategy in the hopes it will allow Portugal to exit the Troika programs into an OMT-style bailout. I believe this strategy will fail and Portugal will not make its targets as the economy and tax receipts decline.”

The gist of my argument here is that the poor economic fundamentals would eventually drag down sovereign bonds and mean that Portugal would be barred from an OMT-style bailout. As it turns out, the opposite has happened. It is still early days as Portugal is a long way from applying for an OMT program. So I could still be proved right in the end. Still, it bears noting how things have progressed since February. And what I am seeing is a widening dichotomy between bond performance and economic performance rather than a narrowing one that drags sovereign bonds down.

Below are the charts for 10-year bond yields in Portugal as well as Spain, Italy and Germany. And what should stand out here is that the yields in Portugal, Spain and Italy have fallen pretty much continuously since the announcement of the OMT program last summer.

Germany’s yields are not correlated with the other three in this sense, as the yield has moved up and down in an unrelated fashion in that time period. So, the yield declines in Spain, Portugal and Italy are most certainly not related principally to inflation expectations. The yield decline is about reduced default risk.

What should also stand out here is that Portugal’s yields started falling before the OMT was announced. So like Ireland Portugal was already on a road of re-coupling to Spain and Italy before the OMT program. Greece is now the only outlier. And I believe it has the greatest upside potential for that reason.

If I could characterize Spain, I would say the yields spiked pre-OMT and then they have been falling ever since. On Italy, the same pattern is apparent. The big difference is that Italy most clearly benefitted from the OMT announcement and the Cyprus deposit grab. You can see where the slope of the yield decline increases dramatically around those two events. We know about the OMT yield decline. Therefore, I think the big takeaway here then is that Cyprus worked in the sense that it has indeed brought sovereign – bank decoupling to the European bond markets. What the Italian chart most clearly shows of all the charts above is that post-Cyprus, sovereign bond risk has diminished because the sovereigns are no longer seen as at risk for the contingent liabilities of their banking sectors.

Portugal is also in the news for moving forward with a front-loaded austerity program that will slash public payrolls despite the economic downturn. And that is certainly a pre-condition of an OMT program. So I do still believe Portugal is making these cuts because they want to have the option of an OMT program. And at present they do fulfill the criteria. What happens then when the economy and tax receipts decline further? In February, I was saying that Portugal would not be able to go OMT then. But right now, that looks to be the wrong call. Like Ireland, Portugal is now on the road to exiting the Troika programs. And like it or not, the deposit grab in Cyprus is a big reason that sovereign yields have come down and will continue to fare better.