Despite LTROs and Self-Directed Reforms, Spain Keeps Dealers Cautious

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April 11th, 2012


Spain’s (and Italy’s) debt servicing costs fell appreciably Wednesday as investors’ appetite for risk returned somewhat and recent laudatory comments from European banking officials smoothed the sharp edges of market sentiment regarding Spain’s fiscal woes. The ECB’s Nowotny, for example, said Tuesday, “The Spanish government is taking the necessary steps which will contribute to help calm the markets.” And while he could not rule out another 3-year long-term repurchase operation (LTRO) in the future, Nowotny saw no present need for an additional cash injection. Similarly, Spain’s central bank governor Ordóñez on Tuesday accepted that banks may need to raise more capital but he rejected the notion that Spain would become the fourth EMU state to require an ECB rescue. LastlyECB Executive Board Member Benoit Coeuré said Wednesday that, thanks to the 3-year LTROs and the measures recently undertaken by Spain’s government, he expects a gradual normalization of the Spanish government bond situation. Nonetheless, he considered ECB bond purchases would still be an option if Spain’s reforms were to go off the rails. As all three officials included the caveat that the economic and financial situation for the euro-zone and its members could reverse again, dealers remain skeptical on Spanish debt.


Providing thoughts on the major concerns about the Spanish financial system, the banking team at Bank of America Merrill Lynch assessed the LTRO’s importance for Spain. “We think that the Spanish financial system’s participation in the ECB’s LTROs is equivalent to 20% of Spanish GDP, which is enough to cover 2012-13 MLT debt maturities. The LTRO has allowed banks to increase their holdings of government bonds to a record level of €240bn (6% of their assets), €68bn higher than in November.”


Debt strategists at Spanish securities dealer Ahorro Corporacion Financiera (ACF) say the pace of public debt purchases by domestic banks (€25.0 bln per month) “doesn’t look sustainable over the long term, especially since additional ECB liquidity injections are not foreseen.” ACF Strategy therefore believes that for the downtrend in interest rates of Spanish debt to continue, there needs to be a renewal of non-resident investment. “As long as foreign demand for Spanish debt doesn’t recover, we don’t foresee a sustainable decline in interest rates, although we do expect a cap thanks to the impact of carry trade deals (5.0% for 10-year rates) and possible ECB secondary market purchases.” In the immediate term, ACF advised that there is no refinancing risk in April (the second greatest monthly maturities of the year after October), since Spain’s Treasury has already raised €30.809 bln, compared to €26.068 bln in maturities.


ACF also noted that since the ECB announced its two 3-year LTROs at the end of November, the result of Spanish banks’ purchases of debt from the Treasury has been a doubling in outstanding registered portfolios, from €70.31bn in November to €142.27bn in February. “This trend (explained by liquidity supplied by the ECB, referenced to repo rates) should continue to favor primary market demand for Spanish debt, especially three-year debt, the main beneficiaries of carry trade strategies. Unsurprisingly, 31.5% of the Treasury’s 2012 issues have been concentrated in the three-year segment.”

Comparing LTRO beneficiaries, Bank of America Merrill Lynch European Rates Research figures Italian banks have better capacity to support auctions than Spanish banks.* “As we have argued, since the 3y LTRO announcement, Italian banks have purchased around €54bn of government bonds, but also accumulated €98bn in bank bonds that are likely to represent retained government guaranteed issuance. Therefore, we believe Italian banks are currently long cash compared to Spanish banks, leaving them in a much better position to support their sovereign bond auctions going forward. In a way, the excess cash generated by the 3y LTROs provides a backstop to any significant rise in Italian yields.”


* Spain’s Treasury will not sell debt again until Thursday, April 19 (details come Friday, April 13). Italy, however, plans to sell €3-5 bln tomorrow, with the issuance predictably concentrated in the 3-year maturity.


Italy’s on-the-run 2-year BTPs trade at a 25.3bp yield discount to Spain’s 2-year notes, though the spread had been as wide as 49.4bp as recently as March 30. The yield discount all but disappears, however, in the 5-year ITL/ESP spread, last quoted at 2.5bp, down from 27.9bp on March 29. Further out the term structure, spreads have been less volatile this month, though Italy currently requires a yield premium of 29.7bp over Spain’s 10-year and 15.7bp over Spain’s 30-year.



Regarding March data for Spanish banks that should be released this week, Societe Generale Cross Asset Research suspects that, “The combined Italian and Spanish banks’ borrowing at the ECB will be close to €500bn in March, up from €365bn in February.” They fear, however, that much of the €125-150bn extra loans will have been invested in sovereign bonds. SG likewise warned, “With underlying sentiment towards sovereign risk deteriorating again – now that the LTRO money is no longer supporting the market – such a leverage trade will look very toxic.”


Partly explaining why they remain cautious on Spain, strategists at Credit Suisse Research wrote Wednesday, “Fiscal tightening is going to be at least 4-5% of GDP. The multiplier on this is likely to be close to one (as it hits the low income groups). The fiscal pain is unlikely to occur until May at the earliest, suggesting a delayed hit (at that stage central and regional fiscal tightening will be €30bn, 2.5% of GDP, even assuming all the previous fiscal tightening has been implemented). The worry is that the bulk of the fiscal tightening is occurring in a situation in which global growth is no longer accelerating and when there is no further LTRO in the pipeline.”

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