Tuesday, 30 August 2011

Falling Irish bond yields

Michael Burke: Irish bond yields are falling. At the time of writing, the yield on 10yr bonds is 8.65%. This is down from the peak of 14.22% on July 15. Yields are inversely related to prices, so bonds have been appreciating sharply. According to Financial Times’ data the benchmark 10yr bond has increased in value by over 40% since mid-July and currently trades at over 76 cents in the Euro, up from less than 54 cents.

Irish government debt is a ‘spread market’, one in which its price is mainly derived from its relative value to other Euro-denominated government debt markets. Therefore, the change in the relative value of Irish government debt is a more important marker of specific factors affecting perceptions of the Irish economy and fiscal position.

The absolute peak in Irish yields coincided with their peak spread over German bunds of 1134bps (basis points, or 11.34%). This was also the peak in the spread of Italian government bonds, known as BTPs. Then the yield spread was 828bps. One week later the Irish yields had fallen to 11.89% and the respective yield spreads over bunds and BTPs had narrowed to 906bps and 648bps. Put another way, while Irish yield were plummeting, German yields were actually heading higher and Italian yields were only falling very modestly.

But that pattern has not persisted, even though Irish yields continue to fall dramatically. Yields on all 3 bonds fell until August 18, when Irish yields reached 9.74%, bunds touched 2.09% and BTPs dipped to 4.95%, for spreads of 765bps and 479bps respectively. Since that time both bund and BTP yields have edged higher but Irish yields have continued to fall. By close of trading last week Irish 10yr yields were 8.82% and bund and BTP yields were 2.23% and 5.09% respectively. In little more than a month the nominal level of Irish yields has fallen by 540bps and the yield spreads have nearly halved over both bunds and BTPs.

Clearly, Irish government debt has participated in a general rally in European government bonds. (In Britain, the post-Iraq BBC is very anxious to support government policy, which it assumes is Eurosceptic and so continues to ascribe stock market declines to the EU debt crisis. It hasn’t noticed either that European debt markets have been rallying while stocks fell or that the current government, fearing a financial apocalypse, has turned Euro-federalist).

Irish Rally

But Irish government debt has also evidently been enjoying a rally of its own, with yields falling more sharply than in other markets and continuing to fall even when others have turned.

It can’t be the ‘recovery’ as the national accounts data, showing a rise in GDP but slump in all categories of domestic demand, was published on June 23- and yields and spreads continued to rise thereafter. It’s tempting to suggest that the all-clear from the Troika was the cause.

But that was released on July 14, and the yields jumped 35bps immediately afterwards. Similarly, much commentary is devoted to the improvement in government finances in the first few months of this year. But the July Exchequer returns (which only provide a partial picture) show the year-to-date deficit at €9bn compared to €7.4bn in the same period in 2010.

There can be little doubt that Ireland has benefited from the ECB’s announcement of bond purchases, which has helped all the crisis-hit countries and now amounts to €116bn. But the announcement was made on August 7, long after the Irish bond rally had begun and so can have only helped it on its way.

Similarly, the reduction in the interest rate on Irish bailout funds will have provided strong support. The summit, 2 weeks after the bond rally began saw the protracted struggles in Greece lead to a reduction in interest rates for both Portugal and Ireland. (The interest rate cut owes nothing to the negotiating skills of the Irish government, as they repeatedly said they weren’t negotiating with EU partners on this point, simply arguing to keep ultra-low corporate taxes). This is the first significant improvement in the fiscal position since the crisis began and will have helped support the rally.

But the catalyst for the rally was something else. The widely-discredited EBA bank stress tests were published on July 15. No matter that the EBA’s entire estimate for European bank recapitalisation was exceeded by the failure of Spanish savings banks just days later, the relief to holders of Irish government debt was the belief that no further state funds would be needed to recapitalise the banks. It was then that the rally began.

Irish sovereign debt is more closely tied to the banks than any other Euro Area economy. So the idea that there will be no further drain from this source underpins the specific rally in Irish government debt. But it might be mistaken. There is an ideological commitment here to placing the interest of the rentiers ahead of those of the economy- the opposite of Keynes’s dictum. And the situation may well deteriorate, as NAMA’s losses tend to indicate. The ‘deleveraging’ process at the domestic banks will leave with an increased dependence on the fortunes of the domestic economy. If the domestic economy fails to recover, bad debts will mount as seems to be happening already in the mortgage market. It is also unclear whether bond investors understand the actual liability to Anglo, where only €3.1n has been borrowed of a projected €47bn requirement to cover promissory notes.


The bond rally was sparked by the idea that no more funds would be needed for the banking system. It has been underpinned by ECB bond buying and the cut in interest rates. But unless the domestic economy recovers, the faith that no further bank bailouts are likely could be misplaced.
Does the rally bring debt sustainability closer? Yes, but it still remains very far away. For debt sustainability the real interest rate minus the real growth rate multiplied by the debt/GDP ratio must be lower than the primary budget balance (primary, meaning before debt interest payments are included). As the debt/GDP ratio is approximately 110% and the primary budget balance approximately -7% of GDP, the current numbers need to go into reverse. What’s needed is 1% yields and 8.7% growth, or a similar gap between the two. Otherwise, rising debt interest payments threaten to overwhelm government finances over the medium-term.

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