IB Interest Rate Brief: Peripheral strains alleviated after European stress tests
Should the European economy slip into another recession or should a sovereign debt crisis erupt once more, only seven financial institutions might not make it through the other side. That is the broad conclusion of last week’s report from the Committee of European Banking Supervisors who revealed the government bond holdings of each of the 91 bankers with the exception of the Germans who refused to reveal their portfolios. Analysts are busy carving up the data looking for fault-lines in the hope they can prove their theory that the tests were insufficiently rigorous. Yet even Goldman Sachs was only looking for just three more failures. As bearish investors find one less reason to call for a break up of the Eurozone, the premium in peripheral government bond prices is slowly dissipating today as yield spreads continue to narrow.
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European bond markets – Only one Greek (haven’t they already had a crisis?) and one (admittedly government-owned) German bank joined the handful of five unknown Spanish savings institutions (yes, count them on the fingers of one hand) to show inadequately capitalized banks as a result of stress testing. The testing translated the impact on banks’ balance sheets after assumed losses of 23% on Greek debt, 12% on Spanish debt and a decline of 20% in European equity prices. Just seven had insufficient tier one capital to withstand the impact. The €3.5 billion shortfall in capital was one-tenth the size of the smallest estimate.
The results have put a spring back into the step of Eurozone investors sending yields lower on those peripheral nations where risk of a blow-up was assumed to be the largest. Italian 10-year bonds rallied enough to shave four basis points off yields while Spanish yields slid by 13 basis points. The yield on Irish government debt also declined by eight basis points while Portugal saw its cost of borrowing decline by three basis points. And as spreads unwind in favor of those less affluent nations they also rose in core nations. German 10-year debt prices slipped sending the yield higher by three basis points as bonds unwind nearly a month of record low borrowing costs.
There was less relief in the shorter end of the curve as measured by euribor three-month futures where implied short-term yields rose between three and seven basis points as month-end funding pressures mount. The commonly hoped for expectation after the stress testing is done is that financial firms will be more willing to lend to one another with a greater sense of financial security. With the results behind us we should look forward to issuance by European banks in order to deal with defrosting the tundra-like corporate bond market.
Eurodollar futures – A surprise increase in new home sales during the month of June to a seasonally adjusted 330,000 units helped tip the September 10-year Treasury note future lower accelerating a rise back above 3% for its yield. Strengthening corporate earnings are conflicting with signs of an economic slowdown, while the smooth landing of the Eurozone banking tests is also detracting from the safety of bonds and fixed income this morning. An earlier Chicago Fed index of economic activity tipped in to the contraction zone for the first time since April, but is a lesser watched indicator and carries little weight in this morning’s trade. September note futures at 122-13 are at a one-week low.
British gilts – Yields are unchanged over the weekend after the stress tests. While the results have boosted investor appetite for riskier assets including the British pound, there is little chance of an interest rate increase anytime soon from the Bank of England. September gilts are nevertheless closing in on Friday’s weakest point at 120.28 and a loss of support there will likely trigger further gains for yields. Short sterling futures are towing the line with U.S. and European markets with implied short term yields adding between three and six basis points.
Japanese bonds – Fears for a further slowdown in the pace of economic recovery helped support government bond prices despite a rebound in regional equity prices. The September JGB future rose 10 ticks to 141.79 carrying a yield of 1.051%.
Canadian bills – There seems to be a bid behind Canadian government bonds this morning keeping its performance at odds with other markets. The spread between U.S. and Canadian 10-year bonds is 23 basis points and one could point to a narrowing in the event of a U.S. inspired bond sell off given that it would likely represent a reduction of risk premium following the stress tests rather than a sign that central banks will move to lift short rates any faster than the current snail’s pace (some snails are still way, way behind the starting line for now). It’s unlikely that the Bank of Canada will act any faster now that the impediment of a Eurozone shocker has been lifted given the relative lackluster pace of global economic activity. Canadian 90-day bills are marginally lower by one or two ticks today.
Australian bills – However, Aussie bill implied yields jumped by between four and six basis points in response to the relief from the stress tests. Yields on government bonds were also up by four basis points to 5.227% ahead of a Wednesday report revealing the pace of inflation in the second quarter.
Senior Market Analyst
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