There have been some frank denials of possible European contagion effects from the Irish fallout this week.
Among those suggesting as much have been (via Reuters):
RTRS – UNICREDIT CEO RULES OUT CONTAGION EFFECT FROM IRELAND ON ITALY
RTRS – BANK OF SPAIN’S ORDONEX SAYS EXPECTS MARKETS TO EVENTUALLY CALM AFTER IRELAND RESCUE PACKAGE
ECB’S GONZALEZ-PARAMO: SPAIN ISOLATED FROM CONTAGION
And yet all market indicators on Tuesday were suggesting exactly the opposite.
For example, the spread between Spanish 10-year bonds and German 10-year bunds extended to its widest ever — surpassing its June record.
As Kathleen Brooks at Gain Capital noted; “Spanish spreads are now at a wider level than they were at the peak of the Greek debt crisis”.
Stefano Di Domizio at Lombard Street Research was bolder still, suggesting the current situation was developing into a European debt liquidity crisis with Spain and Italy occupying front-row seats.
As he noted:
Speculative attacks are now targeting Spanish and Italian bonds, which could hardly be defended given the ECB’s timid bond purchases. With buy-side demand likely drying up, dealers are capitulating on their Bonos and BTPs-packed books, which could trigger a new liquidity squeeze in EA govvies. We recommend hedging the risk of an escalating EA debt crisis via EUR/USD 3m5y conditional tighteners via 25bp OTM receivers (exploiting the recent jump in USD gamma)
Despite market rumors (and a lot of headlines in the news) of large bond purchases by the ECB, just over €0.7bn were bought as part of the ECB’s SMP last week, arguably still way off the size warranted to take some pressure off EA government bond markets. As we have pointed out several times recently, the ECB does not seem to have many bullets left on its SMP, which was originally engineered to address illiquidity risk in bond markets. Again, the Germans are not happy with the program, as Bundesbank’s Weber does not miss to remind us every time he opens his mouth (as recently as Friday last week he remarked that “the ECB’s bond purchases should be stopped sooner rather than later”).
Those likely are the reason why bond markets’ focus is now likely to move towards the big targets, i.e. Spain and Italy, whose bonds are very unlikely to be defended by the ECB with enough conviction to have a major effect.
And if a liquidity crisis in bonos and BTPs was to take hold, Di Domizio says the two countries are particularly badly placed to deal with it:
Because of the Spanish high deficit and the Italian high debt, the two countries look particularly exposed to the case of liquidity drying up again in secondary markets (like in May/June this year).
Normally, dealers absorb large quantities of Bonos and BTPs in their books, ensuring primary bond markets run smoothly. However, the recent fall in bid-to-cover ratios suggests they are now increasingly unhappy doing so, as their books are already burdened with a lot of Spanish and Italian government paper which they are likely struggling to offload in the secondary market.
We doubt buy-side demand for such paper is strong enough to offset increasing supply at the moment, which means dealers’ books are set to get heavier going forward. Although the last thing dealers’ want is to crowd out the remaining demand from bond investors, they are now likely capitulating on their positions, sending Bonos and BTPs yield spreads wider. Bid/ask spreads would also move wider, in turn causing trading volumes to fall, just as it happened earlier this year.
If that’s not contagion … what is?
Related links:
Spanish contagion heads for the bonds [updated] - FT Alphaville
Contagion fears over ‘too big to bail’ Spain – FT
Spain shakes, rattles and rolls – FT Alphaville