Fears over the subordination of private creditors in favour of the official sector in any Spanish debt restructuring, the lack of wholesale financing for the country’s banks, Greece''s elections and the Bundesbank shooting down a mooted eurozone banking union have all conspired to trigger market panic, with 10-year Spanish yields hitting 6.8% on Tuesday.
Spain’s two-year note, at the time of writing, is yielding above 5%.
For the sovereign credit realists, it was always naive to expect Spanish yields to tighten materially, without European Central Bank (ECB) intervention, especially since the eurozone bond market, save for Germany, has been hit by a negative structural shift in the investor base. So, even on good-news days, there are a non-trivial number of legitimate reasons why eurozone bond yields could underperform the news flow.
Market fears now centre on whether Spain can live with these high yields – with a €90 billion sovereign issuance plan in 2012 – the lack of drivers for spread compression, the negative sovereign-bank feedback loop, and the darkening outlook for Spanish collateral.
On the latter, on May 18, clearing house LCH.Clearnet hiked the cost of holding Spanish bonds as collateral for repo purchases as bond yields spiked. The bond clearer said it would raise the initial margin on two- to 30-year Spanish debt, with charges on 10-15 year maturities rising 70 basis points. The move threw into sharp relief the procyclicality of fixed-income trading, with Spanish banks, faced with vanishing collateral values, forced to delever further and tap yet-more ECB funds.
If Spanish government yields rise further, LCH. Clearnet – which has stated that yields rising 450bp above AAA eurozone countries is a key basis for margin hikes – will consider further charges. In a chat with Euromoney, Nomura’s fixed-income strategist Guy Mandy mulled whether Spanish yields breaching 7% could be a trigger for further margin hikes:
"If volumes are high and clients are using high-volatility assets as collateral, there might be demand for higher margin requirements. Although LCH.Clearnet is supposedly using objective criteria, I am sure the criteria is, to some extent, relatively subjective and they will take any decisions very carefully since they are sensitive to the market sell-off caused by margin hikes on Italian debt last year."
A bigger concern is that Spain’s credit downgrade by Fitch to BBB from A is not the last – and will have greater implications for haircuts on ECB collateral, he says. In a seperate report, he noted:
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"If all three rating agencies move Spain to BBB+ or below then under the ECB''s current framework it moves into the Step 3 collateral bucket, which requires an additional 5% haircut across maturities. In classifying its risk management buckets, the ECB uses the highest of the ratings to determine an asset’s position (unlike the sovereign benchmark indices which generally use the lowest). S&P is already within this Step 3 bucket. Only Moody’s currently rates Spain one notch above it at A3, but with a Negative outlook in place, leaving only a small downgrade margin before Spain migrates to the lower ECB bucket. We would hope ECB pragmatism prevails with a move to be more accommodative on its collateral haircut rules on sovereign debt. We hope to see a statement from the ECB prior to this becoming a market issue or we think consequences could be highly market negative" |
The long-term refinancing operations have artificially enhanced the liquidity of poor-quality assets and structurally linked the fates of eurozone banks with sovereigns like never-before.
Given the self-interest the ECB has to preserve the value of its collateral on its balance sheet, the fact that rising short-term Spanish bond yields could trigger money market stress despite systemic liquidity – impeding the transmission of monetary policy – and the need for the market to shrug off Spanish debt restructuring risk, the ECB will be forced to embark on the nuclear option, Mandy says: to publicly declare it will cap eurozone sovereign yields to 5.5-6% until normal market conditions are restored.
Granted most analysts reckon short-term yields on Italian sovereign debt need to rise before the ECB even considers LTRO3, let alone full-scale quantitative easing with a yield target. But Mandy''s rationale is solid: LTROs work when collateral values are stable. If repo funding via the ECB takes place against a backdrop of significant capital losses on government debt, market fears will reign supreme and a more aggressive ECB policy response will be needed.