MacroScope

Portugal crisis to test ECB´s strategy

July 3, 2013

Portuguese bond yields surged to more than 8 percent as a government crisis prompted investors to shun the bailed-out country, raising concerns about another flare-up in the euro zone debt saga.

The resignation this week of two key ministers, including Finance Minister Vitor Gaspar who was the architect of its austerity drive, tipped Portugal into a turmoil that could derail its plan to exit its bailout next year.

Portuguese bond yields surged to levels near which it was forced to seek international aid two years ago. The sell-off spread to Italian and Spanish debt markets, but was not as pronounced there.

According to Elwin de Groot, senior market economist at Rabobank:

This could quickly bring Portugal into a situation where there will have to be decisions about whether there is another extension of the support programme.

It will also bring back discussion on whether the ECB has any interest in trying to prevent further increases in Portuguese yields and whether or not it will be willing to do so.

Euro zone debt markets have been relatively calm since the middle of 2012, around the time the European Central Bank promised to buy the bonds of struggling euro zone sovereigns under certain circumstances.

But volatility after the Federal Reserve hinted it may be preparing to curb monetary stimulus later this year underscored the precarious foundation of this stability and the dependence of markets on abundant central bank liquidity.

Ten-year Portuguese government bond yields and the cost of insuring Portuguese debt against default surged to their highest since November 2012. Ten-year bond yields hit a high of 8.2 percent, before falling back to 7.5 percent.

Portugal would have to be growing at a 7-8 percent annual rate to be able to afford servicing its debt at these yield levels in the long run, de Groot said. The economy contracted 4 percent on an annual basis in the first quarter.

Analysts said the tamer sell-off in Italian and Spanish debt, albeit still large, indicated support from domestic investors and continued faith in the ECB’s bond-buying programme.

Threadneedle Investments fund manager Martin Harvey said his firm’s global funds had already been reducing exposure to Italian and Spanish debt because of concerns over global central bank liquidity, but would stay put for now.

We believe this is not a systemic issue at the moment, although we are watching it closely.

Only if we were to see increased likelihood of PSI (private sector involvement in potential debt restructuring) or more talk about euro exit from either Portugal or Greece would we be really concerned about serious contagion into Italy and Spain.

Higher borrowing costs for longer could, however, hurt Portugal’s chances of exiting its bailout without further support and could make markets more prone to testing the ECB’s resolve. When Portuguese yields rose above 7 percent during the Fed-led sell-off, analysts had already started to worry about Portugal´s debt sustainability.

Thushka Maharaj, European interest rate strategist at Credit Suisse, said at the time that Portugal was unlikely to manage a clean exit from its EU/IMF bailout program. It will likely need a precautionary credit line that would amount to an extension of the current bailout, and this would not be well-received by the market, she said.

Mario Draghi’s news conference on Thursday could not have come at a more sensitive time. As the crisis unravels in Portugal, investors will look to the ECB chief for reassurance.

Still, analysts worry verbal interventions may be less effective the more often they are deployed with being backed by concrete action.

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