Short Note on Euro Zone Success: Ireland?

By Marc Chandler

With speculation still running high that Greece will be forced into a disorderly default and possibly leave EMU, the euro zone problems seem to be intensifying. S&P moved to cut Italy’s credit rating yesterday and Moody’s is expected to follow suit in the coming weeks. Spain’s credit rating also looks particularly vulnerable especially in light of recent comments by rating agencies in light of the regional deficit overshoot and downgrade of a few of the largest regions.

In the deluge of negative news, there is, if not a silver lining, at least a bright spot that does not seem to enjoy wide recognition: Ireland. While Greek and German 5-year CDS are trading at new record highs today, the cost of insuring Irish sovereign exposure peaked near 1180 two months ago and is trading near 813 today.

Irish bond yields have also tumbled. The generic 10-year yield peaked in mid-July near 14.2%. Today its yield is near 8.60%. It finished last year just above 9%. The 2-year bond yield today is near 9.25%. It peaked on July 19 near 23.5%.

Irish equities are modestly outperforming as well. Ireland’s overall index is down 14.3% year-to-day, compared with a loss of 17.6% of the Dow Jones Stoxx 600. In the past month, the Irish market is up 2.1%, while the Dow Jones Stoxx 600 has gained 1.8%.

The reason for the better performing Irish assets is that it has found a way to square the proverbial circle. Pursue austerity and yet experience growth. It has enacted at least six packages of savings since July 2008 and more savings this year. The IMF expect the Irish economy to expand this year for the first time since 2007. The Irish economy expanded 1.3% in Q1 (quarter-over-quarter). It reports Q2 GDP figures on Thursday (Sept 22) and while it most likely did not maintain the Q1 pace, the year-over-year growth may have accelerated toward 0.5% from 0.1%.

Unlike many countries in the euro zone, especially on the periphery, Ireland runs a trade surplus. The July trade surplus will be reported tomorrow. In June Ireland reported a record trade surplus of 4.08 bln euros.

Even before the crisis, we recognized that weak political leadership limited the ability to enact bold policies. The Irish government appears stronger than most in the region. The Kenny-led coalition government has 112 seats compared with the opposition’s 53 seats. And despite the austerity measures, Kenny’s popularity appears to have risen in recent months.

Kenny had to backtrack on what at the time was seen as a key campaign pledge to give senior bank bond holders a haircut, he did manage to win concessions from the EU/IMF to reduce the interest rate of the aid package and extend repayment period and this is thought to save Ireland more than 1 bln euros a year. Kenny managed to win these concessions without have to raise the corporate tax schedule rate, which had been a demand of some of its EMU partners.

Ireland has also attracted foreign direct investment inflows. A large private equity fund bought a bit more than a third of a stake in the Bank of Ireland and a US-based pharmaceutical company is expanding its existing operation in Ireland.

The odds appear to have also improved that Ireland may be able to return to the capital markets next year. Ironically, a significant risk to Ireland and the trajectory depicted here is a further blow up of other peripheral countries and a further slowing of the euro zone and world economy.

That said, it is remarkable that Irish 10-year yields have completely decoupled from Greece. At the beginning of the year, the 60-day correlation between Irish and Greek 10-year yields was above 0.90. Today, the correlation stands at -0.42. At the same time, Irish 10-year bonds yields have become significantly more correlated with German bund yields. That 60-day rolling correlation is near 0.85 today. As recently as late July, Irish 10-year bonds were inversely correlated to bunds (-0.90). This is not to say that Ireland is a safe haven, but…