Peripheral sovereign debt markets have performed exceptionally well since late July. Just before European Central Bank president Mario Draghi told the markets that the central bank was prepared to do whatever it takes to preserve the euro, the 10 year Spanish Bono yield peaked at 7.75%. Since then it has collapsed by more than 200bp. At 5.8%, yields are close to six month lows.
Inevitably, the speed and extent of this rally have given rise to doubts over its sustainability. In the last few days, these misgivings have been expressed by the euro weakening against the dollar and the iTraxx Senior index trickling wider.
The trepidation could well be exacerbated on Friday, when US consulting firm Oliver Wyman publishes its estimate of the cash needed to recapitalise Spain’s ailing banking sector. Analysts reckon that the country's banks need something in the order of €80bn-€100bn, but there is growing speculation that Oliver Wyman will come out with a number perhaps as low as half that level. That could trigger a renewed run on peripheral markets.
Even if this happens, it seems unlikely that the ECB will go back on its word. Europe’s financial institutions are certain to remain flush with central bank liquidity. There should now be little doubt that the central bank is ready to pull the trigger and start buying when the time comes.
Having moved so far in such a short time, peripheral debt markets could be due a correction. But given the surfeit of liquidity and the European Central Bank’s declaration to cap yields, any sell-off may prove to be short lived. Peripheral bond yields should remain anchored down — not so low as to be uninteresting, of course, but low enough not to be excessively interesting. The hunt for yield ought also to benefit other markets offering a return that is high relative to the risk taken, like ABS.
Core markets, however, could be the losers — even, whisper it quietly, German Pfandbriefe. Bankers got a whiff of this on Tuesday when Deutsche Hypothekenbank priced its second covered bond of the year. Despite leaving the book open for more than five hours, the leads were unable to say whether the puny €500m deal had attracted enough orders to be fully subscribed.
The final spread of mid swaps plus 4bp was the tightest for any seven year covered bond this year, but the pushback evident from even the product's own domestic buyer base was still startling. The headlong rush into core European assets may have reached its peak.