European Bonds: Ignoring Politics?

Mid Week Bond Update

European Bonds: Ignoring Politics?

Economics took a back seat to politics in European market last week.

A week ago, the European Commission (EC) sent Italy’s budget back to the government, with instructions to bring it into line with EU guidelines – the first time a country’s budget was rejected.

Italy’s government and corporate bonds matter, not least because they are widely owned by banks throughout Europe whose balance sheets are closely tied to the fate of these bonds.

And yet, Italian yield spreads have been relatively unmoved since the budget was rejected by the EC;  stabilizing, at least for now, roughly between 285 and 320 basis points (bps) above benchmark German 10-year yields. Instead, the big move in spreads happened around the formation of Italy’s current governing coalition in May, when spreads rose from about 130 bps to as high as 290 bps.

So one question Italy’s bond market appears still to be asking: what would it take to escalate the crisis? Or is the market speculating whether the current Italian government will last?

 

Italy’s 10-year BTP spread over Bunds have reacted with relative calm to the EC’s rejection of Italy’s budget

Source: Bloomberg, October 31, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Meanwhile, epochal political change in Germany was also greeted with relative calm, as Chancellor Angela Merkel bowed to her steadily eroding support by announcing that she won’t seek reelection in December as head of the center-right Christian Democratic Union, a role she has held 18 years.  

Of course, in both cases, there’s more to the story.  In Germany, Chancellor Merkel’s term as Chancellor runs for another 3 years, though she could be forced to resign before that if a vote of no-confidence were to succeed. In Italy, observers note that the country’s governments are famously short-lived, and the only thing holding together this particular coalition might be the open-handed budget they are currently being asked to revise.

On the Rise: Optimism in Brazil

The 55%-45% margin runoff win of far-right candidate Jair Bolsonaro in Sunday’s election was expected by many, and financial markets have been relatively calm so far.  The Ibovespa stock index rose just under 1.5% over the two trading days since Sunday, more than recovering from its initial 2.25% downdraft on Monday October 29th. Though the Brazilian real fell about 1.2% against the U.S. dollar, the country’s U.S. dollar-pay 5-year bond ended up roughly where it started, at a yield of 4.43%. The local-currency equivalent did slightly better, resulting in yields falling from 9.533% to 9.166%. With financial markets apparently nodding their approval, the new president-elect may have some additional flexibility in the early days of his government.

On the Slide: Mexican Peso

Not only was the Mexican peso the best performing emerging market (EM) currency for the first three quarters of 2018, it was also one of three EM currencies which rose against the U.S. dollar, gaining just over 5%.

But since the end of Q3, the peso was the second-worst performing EM currency, falling nearly (-6.8%). Only the Colombian peso, at (-7.4%) did worse. Most pointed a finger at President-elect Andrés Manuel López Obrador’s announcement that he plans to halt development of a new airport for Mexico City, saying that he decided to “obey the mandate of the citizens” three years after the beginning of construction of this $13bn project. The alternative:  adding capacity to the maxed-out current airport, a second existing airport in the city of Toluca, and adding two runways to a nearby military airport.

The concern, of course, is that the willingness to abandon long-standing contracts already in progress raises the spectre of greater risk on sovereign as well as corporate debt.

 

All data: Source: Bloomberg, October 31, 2018, unless otherwise indicated.

 

Definitions:

Buoni del Tesoro Poliennali, or BTPs, are Italian government bonds, issued in fixed-rate medium- and long-term form. The three-, five- and 10-year bonds are issued every two weeks while 30-year maturities are issued every month, with a six-month floating coupon.

Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.

 

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