August 14, 2012

Ken Orchard Ken Orchard, T. Rowe Price Sovereign Credit Analyst

European Central Bank (ECB) President Mario Draghi recently sketched out a plan that could be a significant positive for the eurozone periphery. However, it will not solve the underlying causes of the eurozone crisis, such as competitiveness imbalances, fiscal deficits, and excessive debt, and several risk factors remain.

The new ECB plan is a significant positive for the periphery…

Draghi's proposal to Spain and Italy—request a financial support program, sign a memo of understanding, and implement tough fiscal and structural reforms—is compelling. In return, the ECB will anchor the short end of the sovereign yield curve so that the governments can continue issuing bonds. The ECB is also considering other nonstandard policy measures to ease the flow of credit to the private sector. This should lead to a general reduction in risk and lower Spanish and Italian yield spreads.

Draghi's plan addresses two of our greatest concerns: the current high interest rates/low-growth trap that makes deficit reduction and economic adjustment extremely difficult and Spain and Italy's need for official external financing to replace the withdrawal of private sector capital.

…But the plan has short- and long-term drawbacks

Spain and Italy are reluctant to surrender their economic sovereignty. While the governments' opposition to a bailout program has diminished, some hope that the existence of the plan will sufficiently reduce yield spreads so that a formal request for assistance becomes unnecessary. This could keep periphery yield spreads volatile over the next month or so—at least until Spain throws in the towel.

The plan does not solve the underlying causes of the eurozone crisis. The ECB cannot solve the competitiveness imbalances, fiscal deficits, and excessive debt levels that make the crisis so pervasive. The eurozone's future will be uncertain until those problems are sufficiently resolved. Nevertheless, the plan should buy some time for the countries to have a decent chance at resolving their problems.

Spanish and Italian bond yields have probably passed their cycle peaks

Short-term Spanish and Italian bond yields have fallen significantly over the past few days, causing their yield curves to steepen. The curves are now back to levels seen in March 2012—not long after the ECB's second long-term refinancing operation at the end of February—when both short and long yields were around 150 basis points lower. This is the steepest the curves have been in the euro's history.

Given the uncertainty around rescue program requests, yields could be volatile over the next few weeks as the markets and sovereigns feel out each other's positions. Eventually, we think long-term Italian and Spanish bond yields will follow short-term yields lower. The ECB wants to eliminate uncertainty about the euro's future and fix the monetary policy transmission mechanism (i.e., reduce private sector interest rates). Current spreads for Italy and Spain are inconsistent with such a reduction in financial stress.

Eurozone stress should decline, but five risks need to be watched:

1. Spain and Italy could decline to sign memos of understanding and enter programs. Spain has repeatedly refused to request assistance from the European Financial Stability Facility/European Stability Mechanism. At an August 6 press conference, Spanish Prime Minister Mariano Rajoy refused to say whether Spain would make an official request for assistance or not. Italian Prime Minister Mario Monti has sounded more ambivalent about requesting assistance.

2. More sovereign rating downgrades may occur. Moody's has stated that countries in official rescue programs cannot be rated investment grade. Therefore, Spain and Italy will likely be downgraded to below investment grade after they request financial assistance. The short-term market reaction would probably be negative. Longer term, however, we think the market will ignore a Moody's downgrade. S&P and Fitch are likely to view the combined EFSF/ESM/ECB actions as supportive for Spain and Italy and to maintain their ratings in the BBB range. This would also keep Spain and Italy in the major investment-grade bond indices.

3. Greek political problems and/or a euro exit are likely. Greece is a powder keg. The economy is still in deep recession, and unemployment is rising. A government collapse and/or a departure from the eurozone are still likely next year. We believe this is one of the reasons that the ECB wants bigger firewalls for Spain and Italy.

4. The German constitutional court could reject the European Stability Mechanism (ESM). The German high court will rule on September 12 whether the ESM is consistent with the German Basic Law. The high court has never ruled against a crisis support mechanism, and we do not expect it to do so this time, but it could place some constraints around the ESM's operations and size.

5. Italian politics could be destabilizing. Italy will probably hold parliamentary elections in April 2013. Some parties could run on an anti-austerity/anti-bailout ticket. Some, notably the 5 Star Movement, may even run on an anti-euro ticket. That could be destabilizing.

The views are as of August 10, 2012 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.