MONETARY POLICies
in Italian bond yields took market participants by surprise. Following the decision by a UK-based clearing house to raise margin requirements, Italian 10-year bonds lost 5% in value as yields soared to 576 basis points above the German bund. Tis episode sparked concerns that a prolonged period of bond market turbulence could end in a self-fulfilling funding crisis in the third largest bond market in the world. Yet simple simulations of the debt service costs to the Italian Treasury
in different yield curve
scenarios suggest that Italy should be able to withstand elevated yields for some time, provided it retains access to the market. Given the relatively high average residual maturity of the Italian public debt (seven years), it would take a long time for elevated yields to translate into significant additional debt service costs. Bond market tensions increased further even aſter new governments took office in Greece and Italy to implement reforms. Te rise in spreads accelerated across the board. Tis run-up brought some sovereigns financing costs up to pre-euro levels. Spain issued 10-year bonds at a shade below 7% on November 17th; 12 days later, Italy did so at 7.56%.
Te Eurosystem continued to purchase limited quantities of government bonds, bringing its bond holdings under the Securities Markets Programme (SMP) to 207 billion euro by December 1st (see BIS Chart of Securities Markets Programme). During some of the more volatile days in November, the run-up in yields was reportedly
FX
Bond
market
tensions
increased
further
even after new governments took office in Greece and Italy to implement reforms
halted only by official purchases. However,
the Eurosystem resisted
mounting international pressure to embark on large-scale purchases. In repeated rounds of selling, investors tried to offload sovereign bonds previously
considered safe. Yield
spreads of Austrian and French bonds approached 200 basis points, and even Dutch and Finnish yields broke away from those of German bunds. Te bond market selling pressure thus permeated ever deeper into the core, leaving the bund as virtually the only trusted AAA paper in the euro area. Te universe of trusted paper thus seemed to shrink just as the demand for safe assets was rising, prompting a flight to safety to assets outside the euro area. Even the German bund
auction on November 23rd was poorly subscribed, raising just 65% of the target amount. Although markets calmed down at end - November, these dislocations in some of the largest euro area bond markets unsettled market participants; they may have inflicted damage to the investor base, given that long-term investors such as insurance companies and pension funds rely on sovereign debt markets for the preservation of capital. With confidence in the ultimate solvency of bigger borrowers as Italy and Spain at risk, we enter 2012 with a heavy auction schedule
facing European
issuers. So the future evolution of the ECB’s SMP is what most market players are trying to gauge planning their investment decisions.
FX TRADER MAGAZINE January - March 2012 33
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