Head of Fixed Income Strategy
Summary: As yields in the US continue to rise, rotation from European sovereigns to the US safe-havens becomes more appealing. A second European sovereign crisis will begin with the sell-off of Greek government bonds, quickly leaking to the periphery, particularly Portuguese and Spanish debt. Italian debt will prove more resilient than peers as domestic investors own most of it, and Mario Draghi's leadership will weigh positively on market sentiment. In this scenario, the European Central Bank's current monetary policies - the Pandemic Emergency Purchase Programme (PEPP) in particular, will prove inadequate. The ECB will need to revise its quantitative easing policies to direct efforts straight to those countries affected by the crisis. Such measures will provoke the spread versus the Bunds to compress, leading towards a better monetary union.
Since the beginning of the year, 10-year US Treasury yields rose by more than 70 basis points. European sovereigns followed, but the rise in yields was contained thanks to the intervention of the ECB's increased purchases under the Pandemic Emergency Purchase Programme (PEPP). Yet, the threat coming from higher yields in the United States is not totally removed. If inflation expectations rise substantially, we can expect US yields to continue to increase, dragging European sovereigns with them. Although the Federal Reserve might accept higher yields as the economy recovers, this is something that the ECB wants to avoid at all costs.
Still, the ECB is fighting an uphill battle because it is left alone to stimulate the economy without fiscal stimulus. At the same time, US Treasuries begin to offer an appealing alternative for yield-starved foreign investors, posing European sovereigns to rotation risk. Indeed, once hedged fully against the EUR, US Treasuries with 10-year maturity provide a yield of -0.18%, approximately 13 basis points over the Bund. However, the situation gets even more alarming when looking at the periphery.
Portugal pays around 0.23% for 10-year government bonds, 41 basis points over fully FX hedged US Treasuries. However, in light of capital requirements, it is more expensive for banks to hold Portuguese debt than US Treasuries, eroding this differential further.
It is worth considering that not all investors hedge their FX risk because income opportunities are scarce, with about 35% of all non-US debt providing a negative yield. In this environment, not hedging at all looks like a risk worth taking to maximize returns. Research from Morgan Stanley shows that ideally, it is never good to hedge a position fully against FX risk. For EU investors, the optimal hedging ratio is around 66% of the amount invested, while it's 80% for Japanese investors.
To better understand investors' benefits to buy into US Treasuries versus European peers, it's helpful to consider another hedging strategy involving three months rolling forwards. In that case, yield erosion would be sensibly lower, and 10-year US Treasuries would provide a yield of around 0.92%, seven basis points over 10-year Greek government bonds. How would another European sovereign crisis unravel?
It is clear that as long as Federal Reserve and the ECB’s monetary policies diverge, the more exposed are European sovereigns to rotation risk. It is necessary to highlight that many European investors don't have a choice other than being invested in sovereigns from the bloc. Thus, domestic demand will remain solid, while foreign demand will fluctuate. In the past, foreign investors bought into European sovereigns because the aggressive monetary policies of the ECB provided support to these securities, assuring capital appreciation. However, in 2020 yields have dropped dramatically, making all euro debt unprecedently expensive. Portuguese 10-year bond yields, which at the peak of the 2011 European sovereign crisis rose above 12%, fell into negative territory last December. Foreign investors are undoubtedly starting to see that, in light of yields rising in the United States, holding debt from the periphery provides a more significant downside than upside. Foreign demand is volatile because it is not bound to geographical restrictions. Therefore, a rotation from the European periphery, which carry the most significant political and economic risks, becomes a real possibility.
We believe that any selloff in the periphery will begin with an exodus from Greece. Foreign investors hold almost 90% of Greek debt. Additionally, Greek debt is rated junk due to its serious creditworthiness issues, which the coronavirus outbreak has exacerbated.
It is important to consider that Greek debt is sensibly more illiquid than any other of the periphery, with only €86 billion of bonds outstanding, adding to the risk of holding it.
A selloff in Greek debt would immediately be followed by Portuguese and Spanish debt as foreign investors hold almost half of these countries’ debt.
Italian debt outshines peers
Italian government debt’s investor base is the most solid of the periphery. It has the lowest percentage of foreign investors holding its debt and the highest share of domestic banks and nonbanks owning it. What makes Italian government bonds better than peers is that domestic non-speculative investors with a long-term investment horizon hold the greatest part of the country's debt.
The Bank of Italy has been the biggest purchaser of BTPs in the past six years. Since 2020, the central bank increased Italian government bonds purchases under the PEPP programme to weather the Covid-19 pandemic. During the pandemic, BTPs demand from domestic and foreign banks increased, showing that whenever Italian yields rise, banks are net buyers, providing ample support.
It is also important to consider that Mario Draghi's arrival in Italian politics provides additional support to its sovereigns. Indeed, while other European government bond yields rose by roughly 25 basis points year to date for 10-year maturities, BTPs yields rose only by half. That's why we are confident that in the case of another European sovereign crisis, the selloff in Italian BTPs will be contained compared to peers. Any widening of the spread versus the Bund can provide an exciting opportunity for real money to buy Italian debt cheaply.
How severe can be the selloff in the periphery?
Sovereigns from the periphery should offer a pick up over the US safe haven, but how much over Treasuries should they offer to be attractive?
To answer, it is helpful to look at the average spread offered by sovereigns from the periphery over FX-hedged US Treasuries since the end of the eurozone crisis.
Since 2014, Spanish Bonos have paid on average 80 basis points over EUR-hedged US Treasuries. It is also the tightest average spread paid by a southern European country over US debt in the past six years. It leads us to believe that, on average, countries from the periphery should offer at least 80 basis points over the US safe-havens to compensate for the risk they carry. Therefore, 10-year Bonos should pay around 1.15% in yield, representing a fall of 7.8% from current prices.
The selloff will be disproportionally skewed towards countries with higher participation of foreign investors, such as Greece and Portugal. Since the end of the European sovereign crisis, Greece offered on average 475 basis points over FX hedged US Treasuries. It means that a selloff could provoke a loss of as much as 36% in 10-year Greek government bonds.
A powerless European Central Bank will be forced into unconventional QE measures
Facing another European sovereign crisis, the ECB will find that it has run out of bullets. The Pandemic Emergency Purchase Programme (PEPP) will prove useless because allocation through the Eurosystem capital key of the national central banks favours Bunds over other sovereigns. In the scenario we are considering, investors would sell the periphery to buy the US safe-havens. Once that a full-blown selloff ensues, European investors would rush to buy Bunds, provoking even a faster widening of the periphery's spread versus the Bunds. One of the ways that the ECB can tackle the crisis this time around will be by trying to push for the politically unpopular decision to skew the central bank's purchases towards the periphery. It will ultimately lead towards a long term compression of spreads in the euro area and a better monetary union. Another way to look at this would be for the ECB to start buying Treasuries in large quantities, reducing the convenience to rotate into US peers. Such policy, however, would sink the euro and temporarily postpone problems without resolving them. Quarterly Outlook
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