Analysis: Euro zone periphery debt vulnerable after summer lull

By William James

LONDON (BestGrowthStock) – The growing risk of a global economic slowdown could scupper any further tightening of peripheral euro zone bond yield spreads, which will also depend on sovereigns successfully selling debt into a volatile market.

Amid concern over the cost of bailing out the Irish banking sector, weak Greek GDP data and concerns about the bite of austerity plans, a wave of upcoming sovereign bond sales will stretch investors’ appetite for higher-yielding debt.

But this resumption in primary market activity comes as fear over the global growth outlook ramps up demand for safe-haven debt, pushing core yields such as the U.S. 2-year Treasury and the 10-year Bund to new lows.

While recent issues of short-term treasury bills from Spain and Portugal have been successful, the greater volume of bonds hitting the market in September will provide a much stiffer test of whether there is sufficient investor appetite to take on large amounts of long-term exposure to the riskier borrowers.

The difference in yields between lower-credit euro zone countries and benchmark German debt had been narrowing since May, when fears peaked that one or more states could default under the weight of their debt burdens. Peripheral debt then put on a strong rally in late July.

But last week the announcement of Irish supply plans, coupled with concern over the cost of supporting the country’s banking sector triggered a 70 basis point widening in the spread over 10-year Bunds to 314 bps that also dragged other peripherals wider.

Even after Ireland found solid demand for its debt at Tuesday’s auction, the spread has only tightened marginally and remains above 300 bps.

“The price action last week has really demonstrated that the tightening in spreads over Bunds is going to be a real slow grind, and there’s going to be a lot of volatility along the road,” said Kenneth Broux, economist at Lloyds TSB in London.

Greece, the initial focal point of investor fears, continues to draw bets that it will default on its debt despite a European Union and International Monetary Fund financial safety net.

The cost of insuring against a Greek default has risen to 815 bps, over 100 basis points higher than in early June.

SUPPLY HURDLES

Spain, Portugal, Ireland and Italy are all expected to issue new debt totaling up to 30 billion euros in September with Spanish auctions highlighted as most vulnerable to weak demand.

Sovereign Spanish bonds could find themselves competing with an anticipated wave of covered bond issuance from Spain’s embattled regional banks if market conditions appear favorable.

“There could be a lot of Spanish credit in the air at one time, and I’m not sure if the market is really strong enough to take this down,” said David Schnautz, strategist at Commerzbank.

Just a couple of bad trading days could see a return to the euro-lifetime high 10-year spread levels seen in mid-June around 228 basis points, Schnautz said. The spread was last at 165 bps.

For Ireland, concerns over the cost of bailing out the country’s banking sector, with large amounts of government guaranteed securities coming due in September, will continue to remain the sovereign’s weak spot in coming months, despite having made strong progress toward its 2010 funding targets.

Other peripheral sovereign sales are expected to be less pressured, but there will be little let up in the recent trend of investors requiring a large concession to buy the debt, driving spreads wider before each auction, analysts said.

MACRO OUTLOOK

As peripheral states battle to trim budgets while limiting the impact on growth, financial plans for 2011 will also be a key focus, with markets sensitive to any sign that government resolve to address bloated deficits is waning.

But even if markets are satisfied by domestic measures, the storm brewing in the U.S. economy could hit global appetite for riskier debt and cause euro zone spreads to widen anew.

Data showing the U.S. economic recovery is stalling has prompted the Federal Reserve to ease monetary policy again, raising questions over the sustainability of recent outperformance in the euro zone and sending investors scurrying to safe-haven assets.

The U.S. non-farm payrolls employment report due on Sept 3 will be the next milestone for judging the health of the U.S. economy.

“The one million dollar question is whether we get spillover from the U.S. to Europe in Q3-Q4. If that is the case, I think you will see spreads continue to widen regardless of progress that’s being made domestically,” said Lloyds TSB’s Broux.

(Editing by Hugh Lawson)

Analysis: Euro zone periphery debt vulnerable after summer lull