By Benjamin Streed
July 30, 2012
(July 30th, 2012) Every four years the athletes of the Olympic Games attempt to inscribe their name in the annals of history by claiming victory at the world’s most prestigious sporting event. Some are content to simply represent their country, others strive for bronze, silver or gold medals and others still are motivated by the chance to set world records. Legendary American swimmer Mark Spitz, who was the first athlete to win seven gold medals in a single Olympic Games, famously stated, “Life is true to form; records are meant to be broken”. Seemingly taking inspiration from the Olympic spirit referenced in Spitz’s quote, the 10-year Treasury yield hit four consecutive record breaking yields over the last week alone. Monday began with a general “risk off” mentality helping to push the 10-year yield to 1.3875%, the current record-low yield, on Tuesday before backing up towards 1.50% late in the week. On a week-over-week basis, the jump up in yield was the first increase we’ve seen in the last 5 weeks. For the sake of additional perspective, this yield stood as high as 2.377% back in March and has steadily declined ever since.
Despite what the chart above shows, the march towards record-low yields hasn’t been a straight line. Yields are seemingly committed to a constant game of tug-of-war; one day we’ll witness record lows on fears the global economic situation is deteriorating and Europe will be unable to contain its fiscal crisis, while the next day yields reverse course as market sentiment shifts towards the possibility of additional bailouts overseas. Wednesday marked another episode of the latter as European Central Bank (ECB) council member Ewald Nowotny, head of Austria’s central bank, stated that there are “arguments in favor” of providing further power to the European Stability Mechanism (ESM) by granting it a banking license. Should this occur, it would provide the mechanism with direct access to ECB lending and thus the possibility of greater funding and flexibility. Although discussions are apparently “ongoing” and “not specific”, granting the ESM such a license would help provide a more substantial monetary buffer should larger countries such as Spain or Italy require significant financial aid. On the flipside of the argument, some market participants are refuting this concept stating any such plan would amount to the ECB directly financing governments, a practice that prohibited under current European Union law. As a reminder, the ESM currently has €500 billion ($607 billion) at its disposal and could be depleted quickly if any sort of domino-like bailout situation arises in Europe. Amidst the updated comments from Nowotny, Moody’s affirmed the European Financial Stability Facility’s (EFSF) rating of Aaabut changed the outlook to “negative” after the ratings agency gave three of the primary guarantors, Germany, the Netherlands and Luxembourg a similar “negative” diagnosis.
Last week, Moody’s cut the outlook on Germany’s Aaa-rated sovereign debt to “negative” from “stable” citing rising uncertainty surrounding the ongoing European debt crisis. The report focuses considerable attention on Greece and that the struggling country may leave the currency union and that an “increasing likelihood” of collective support for countries such as Spain and Italy were among further reasons for its decision. German Chancellor Angela Merkel immediately refuted the ratings agency stating that Germany will continue to be Europe’s safe-haven during the crisis regardless of the country’s credit rating. Going one step further, the German Finance Ministry commented that the risks in the Eurozone are “not new” and that the country remains “in a very sound economic and financial situation” and that, “Germany will, through solid economic and financial policy, defend its safe-haven status and continue to responsibly maintain its anchor role in the euro zone”. The bond market seems to have already cast its vote, rewarding Germany with record-low borrowing costs despite the obvious likelihood for further Germany-sponsored bailouts for peripheral countries in the monetary union. Although German bonds fell on this particular headline, other European countries fared worse as the potential for German-led aid could dwindle should the country’s borrowing costs somehow begin to rise. Spanish 10-yr notes rose to as high as 7.625%, much higher than the 7.00% level that prompted international bailouts for Greece, Ireland and Portugal. Spain’s borrowing costs calmed late in the week, falling to 6.75% on Friday and marking a 75bp decline since Monday. Interestingly, Spain’s borrowing strategy has been to focus on shorter-term maturities in hopes of paying lower yields, a tactic that has clearly backfired as the country now borrows money for 5-years at nearly the same rate it pays for its near record-high 10-year notes.
By the end of the week the market’s mentality shifted to one of optimism as news out of Europe indicated that policymakers are willing to take additional steps to protect the European Monetary Union. ECB President Mario Draghi states that officials are prepared to do “whatever is needed” to preserve the Euro and help ease the surging bond yields faced by some of its member countries (Spain and Italy). The comments came in direct response to yesterday’s plea by Spanish government officials who stated that ECB policymakers should do more to stem the financial turmoil engulfing everything from their banking sector to their federal and local governments.Draghi noted, “To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate” and, “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.”