The gaping chasm of Spain’s famed Anisclo Canyon has long attracted tourists, but investors are drawn to a more recently formed phenomenon that induces a roughly similar amount of vertigo: the chasm in spreads between Spanish and German government bonds.
This rose on Friday to a euro-era high of 548 basis points (bps), with investors continuing to seek the relative safety of Bunds and abandon risky Spanish debt. In jumpy markets on Monday the spread was down a little but still above 500 bps. Hedge funds and other institutional investors have traded this differential heavily — using it as a handy bellwether for the ebb and flow of markets’ fears about the euro zone debt crisis. But has this become a risky strategy?
In the short term, it looks like a gambit that could yield further fruit.
Despite Spain’s severe fiscal problems, its politicians are proving reluctant to ask for a full bailout from the EU, because the Greek example shows how humiliating this is for a country’s government. It involves officials from abroad taking a fairly tight hold of the reins of power as a quid pro quo for the funding, and Greece’s political turmoil confirms that this destroys the popularity of whichever political party initiates it. Taking a longer-term view, Britain’s Labour government asked the International Monetary Fund for money in 1976, and Labour did not win another general election for 21 years. Spain’s ruling Popular Party is understandably afraid that an ignominious rescue would keep it out of power for a generation.
However, Spain lacks the ability to go it alone — and the market’s recognition of this would push up Spanish-German bond spreads yet further if it attempted to do so.
Its government debt was only 68.5 percent of gross domestic product (GDP) in 2011, according to the International Monetary Fund — below the euro zone average of 88.1 percent. But Credit Suisse finds little solace in this. “The saving grace for Spain is that its public sector debt comes from a relatively low base,” it acknowledges. “But recapitalizing its banks, combined with a weak growth environment, could see Spanish debt rising towards 100 percent of GDP in 2015.”
The government needs to pump tens of billions of euros into its failing banks, against the background of a severely depressed domestic economy which is drying up the flow of tax revenue. At 24 percent, unemployment is the highest among the 34 member states of the Organization for Economic Cooperation and Development, the rich-country think tank. This keeps benefit payments payable by the government high and demand in the economy low. Demand is also deflated by high corporate debt, caused by the spectacular end of Spain’s economic boom. Total private-sector debt — for households and nonfinancial companies combined — is more than 200 percent of GDP.
It is possible that a middle way can be agreed between a full-scale bailout and no intervention at all; the government has floated the idea of EU institutions recapitalizing its banks, for example. But this limited bailout might well prove impossible to agree on because officials in Brussels and in Berlin, homes of the euro zone’s paymasters, are likely to demand that some strings are attached before they agree to disburse tens of billions of euros to Spain. Spanish politicians, for their part, are likely to balk at anything that smacks even of a partial abdication of power.
It seems, therefore, that as Spain kicks the can further down the road leading to a solution, there could be considerable further mileage in betting on widening spreads — in the expectation that it could be months before Spain’s situation is so bad that it finally accepts financial aid on terms largely dictated by its rescuers.
Investors betting on this, however, face a considerable risk in timing: Spain will be compelled eventually to accept a bailout, and when it becomes clear that all of the package’s pieces are falling into place, spreads could narrow considerably and rapidly.
The reduction in differentials will come partly from falling Spanish yields as faith returns that, with the aid of other EU member states, Spain can pay back its debt. But investors will also have to take into account the likely effect of a bailout of German yields — the other leg of this trade.
The yield on ten-year Bunds closed at 1.22 percent on Monday, not far off Friday’s record low, as investors looking for a safe haven within the euro zone remained wary of peripheral countries such as Spain. However, the cost of insuring against a default of five-year Bunds in the credit default swaps market has risen by about 25 basis points since March to 102 points on Monday — meaning that it costs $102,000 a year to insure $10 million of German debt. This suggests that Bund yields are being pushed down by the huge pool of money sloshing around the euro zone looking for a safe home following the European Central Bank’s monetary easing — and not by any firm conviction that Germany is ultrasafe.
Bund yields could move upwards very quickly if investors became worried that a Spanish bailout would increase Germany’s debt burden to unaffordable levels. At above €700 billion ($871 billion) and rising, Spain’s total debt is higher than the combined total for the three euro zone countries bailed out so far: Greece, Portugal and Ireland. If other euro zone countries shouldered this debt burden — perhaps through the European Stability Mechanism, the currency union’s rescue fund — fears would rise again about the debt sustainability of every single euro zone member state.
The trick for investors is, of course, to have moved onto a different spread by that point. A possible candidate for one of the legs of any new spread is U.K. government debt. Late last year gilts bucked the trend of recent economic history when the yield traded briefly below Bunds, after a disastrous bond auction in Germany bedeviled by fears that increasing aggregate euro zone debt would even topple the currency union’s strongest economy. As the euro zone debt crisis worsens, money is again flowing away from the euro zone and into gilts, pushing 10-years down from 2.00 to 1.54 percent in only a month. This suggests that if Spain’s situation becomes direr, going long gilts and short Spanish or even German bonds could be a productive ploy.
