The Italian equivalent of the English idiom, “to kill two birds with one stone”, involves catching multiple pigeons with one bean, apparently. Whatever the precise translation, Mario Draghi has certainly achieved more than one positive outcome while presiding over the ECB’s QE programme. While the primary rationale for large-scale asset purchases was to return inflation closer to target, the ECB’s QE programme also conveniently compressed sovereign debt spreads between core and periphery states, creating breathing space for countries with excessive debt levels. However, the QE programme is now nearing its conclusion and the end to net purchases will bring upward pressure on periphery spreads. Euro area peripherals have also benefited from increased global risk appetite since 2015, a trend that will reverse at some point. Putting these factors together with still worrying fundamentals (high debt levels, weak long-run growth prospects and the concentration of non-performing loans) points to a strong likelihood of spreads widening in 2018.
Compared to peak levels in early 2012, spreads between the yield on debt issued by peripheral and core countries of the euro area are now considerably lower. A range of factors has driven this convergence. The first, and arguably the most significant, development was ECB President Mario Draghi’s pledge in July 2012 to do “whatever it takes” to save the euro. This commitment substantially reduced the perceived probability of a euro break-up. Subsequently, the expectation and later announcement of a euro area QE programme drove down credit spreads. Large-scale central bank sovereign debt purchases introduced a significant new buyer into the debt markets, in effect shifting the demand curve and creating more demand at each price level. By depressing yields of core countries to extreme lows, EA QE also encouraged investors to take on additional risk to meet returns targets (the ‘portfolio rebalancing effect’). Finally, there has been an improvement in the debt-servicing capacity of periphery issuers through sustained fiscal adjustments and a recovery in economic activity. However, the level and trajectory of periphery debt remains concerning, as does the concentration of non-performing loans in a small number of European banking systems.
In understanding the evolution of EA spreads since the emergence of the sovereign debt crisis, it is useful to decompartmentalise the elements of risk that result in investors demanding a premium to hold periphery debt as opposed to German government bonds. Firstly, core and periphery debt yields differ due to varied levels of default risk — the probability that the sovereign will be unable, or unwilling, to meet its obligations. Some of the factors that determine default risk include a country’s current account position, the proportion of government debt held externally and the ratio of domestic credit to GDP. As well as default risk, investors demand a premium for liquidity risk, which tends to be higher for countries with smaller quantities of sovereign debt outstanding, and during periods of heightened volatility. Finally, EA spreads include a premium that came into particular focus during the sovereign debt crisis: redenomination risk. When investors purchase debt belonging to a euro area sovereign, they take on the risk that should this country exit the euro, this debt will be repaid in a new (possibly devalued) domestic currency.
Fathom expects the QE programme to conclude in the autumn of this year. Looking ahead to this ‘post-QE’ world, how will spreads for peripheral countries evolve? We estimated a model for sovereign debt spreads for Italy, Portugal and Spain from the start of the sovereign debt crisis in mid-2010 until the end of 2016. The model uses Fathom’s indicators for default and redenomination risk, as well as including variables which capture the impact of QE and market sentiment. If QE purchases conclude in September, the model shows spreads rising by roughly 50 to 110 basis points from their current levels by the end of this year. These model forecasts of higher periphery spreads are not dependent on any assumed deterioration in the underlying fundamentals of these issuers, nor of any change in perceived redenomination risk. Given political developments in Spain and Italy, where the Catalan independence movement and 2018 elections respectively are causing uncertainty, there is plenty of downside risk to this assumption.
Another source of possible upward pressure on peripheral spreads is a change in sentiment in debt markets. According to a study by Favero and Missale1, spreads between periphery and core EA debt are particularly sensitive to global risk appetite, resulting in a discontinuity in the disciplinary role of financial markets. Recent years have witnessed a prolonged bull market, with junk corporate debt yields being pushed to historical lows as investors take on additional risk. Ultimately, this sentiment is likely to turn at some point, as history tells us it must. While not our base case, a reversal in global sentiment could see risk appetite return to the average level of 2012 — Fathom’s model forecasts spreads rising by between roughly 100 and 150 basis points in this scenario.
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