Friday, July 5, 2013

As Portugal's yield curve flattens, Draghi is put on the spot once again

Financial news junkies love the Eurozone. Just when things seem to quiet down, something always flares up in the region. This time around it is Portugal that has been grabbing the headlines.
The Economist: - NO ONE is likely to emerge a winner from the political disarray triggered in Portugal by the resignations of the finance and foreign ministers. For two years the country has won plaudits as the best behaved of peripheral Europe’s bailed-out countries. But voters have tired of the relentless austerity that Portugal has had to endure under the terms of its €78 billion bail-out programme, and the repercussions appear to have split the two-party coalition government. Portugal’s international creditors, the “troika” of the EU, the IMF and the European Central Bank, are seeing their star pupil brought low by the political and social costs of implementing their rescue plan.
CDS spread hit the high for the year - though nothing close to historical highs.

Source: DB (dates in European format)

And while the media has been focused on the 10-year bond yields spiking, the real action has been in the short end of the curve. The 2-year paper for example moved by some 150 bp in a matter of days.


In fact the yield curve flattened in a manner reminiscent of the dark days of the Eurozone crisis (see post).

One of the concerns with respect to Portugal is that officially the nation may not qualify for the OMT support - the ECB's bond buying guarantee. That's because when the OMT program was announced (less than a year ago), it was aimed at nations that have not yet received the full bailout package from the EU/IMF (which Portugal has). The idea was to limit it to nations that still have "market access". And without the OMT backstop - which is expected to target the short end of the curve - Portugal's short-term paper is vulnerable, resulting in higher short-term yields. That will hurt Portugal's economy because now even shorter dated loans will become expensive (in spite of ECB's overnight rates at 0.5%).

The IMF has been pressuring  Mario Draghi to include Portugal in the OMT program for some time. The IMF is clearly concerned about having to provide additional support for Portugal (see post) and would rather see the ECB come to the rescue.
Bloomberg: - “Eligibility to the ECB’s Outright Monetary Transaction [OMT] program would also go some way in helping improve the monetary transmission mechanism [see post] in Portugal and secure durable market access,” the [IMF] said in a staff report about the seventh review of the aid program for Portugal.
Now the pressure is on the ECB to make an exception for Portugal. From the beginning analysts have said that Portugal should be the first candidate for the program (see discussion). However if the central bank does so, Greece may request the same support from the ECB as well, making the whole process politically tricky. The ECB certainly does not want to be buying Greek bonds at this juncture. Mario Draghi, who officially stated that Portugal will be excluded from the OMT (see post), is once again asked to solve structural and political problems that should not be the purview of an independent central bank.
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