It is just possible that the once unthinkable might happen in the European sovereign bond market in 2011: that it might somehow muddle through with no disasters and no defaults, Greece aside.
In January, markets were buzzing with rumours of mechanisms being constructed to allow Greece to reprofile its debt by buying it back in the secondary market to capture discounts to par of up to 30%, funding the purchase with new, longer-maturity bonds. This would of course require the participation, if not the lead sponsorship, of one large buyer based in Frankfurt. But whether or how it happens is already almost moot. The question is no longer Greece: it is everyone else.
Most market participants had begun the year braced for the imminent calamity of large investors abandoning peripheral eurozone bond markets on the basis that combined official government debt and implicit sovereign liability for bank debts simply looked unsustainable. Certainly some investors had stepped back in the final month of 2010; others had been prevented by their own risk managers or by their mandates from buying downgraded European debt. Government bond traders feared a prolonged buyers’ strike.
Four weeks do not make a trend. But it’s so far, so good for the bond markets in 2011, with bankers taking comfort from the large books of orders built for benchmark deals for the EU, Spain and for the EFSF and others. January is always busy and this year has proved no exception, with investors putting fresh cash to work subscribing for new deals.
February will probably prove more nerve wracking. Yet while it would be foolish for bankers, investors or policymakers to draw too much comfort from those first oversubscribed successes, they at least allow the optimists to set out a case for how the financing markets might continue to function this year.
The optimistic case depends on several linked strands. First, the panic that had previously attended every auction by each troubled peripheral sovereign must subside. At the very least, the provision of emergency funding to Greece and Ireland last year has reduced the number of troubled auctions that might provoke a wider panic. Those cases also provided investors with a rule of thumb that multilateral intervention becomes more likely when benchmark 10-year sovereign bond yields exceed 7%. When yields rose above this level in the run-up to a key Portuguese bond auction at the start of January, the European Central Bank stepped in to buy and drive them down. The subsequent auction got away.
Can the market carry on like this? To an extent, it is already being propped up – rigged might be a less kind way to put it – by official-sector buying that should discourage wide-scale shorting. Without this artificial support, the market could not function today and it is highly questionable whether the government bond market today provides an efficient mechanism for pricing and providing credit.
At the same time, Europe is stumbling closer to some kind of agreement on how to deploy its backstop financing mechanisms so as to subsidize the funding needs and costs of its weaker sovereigns by using the credit strengths of the stronger. In March, there will be further announcements on how large these backstop funds will be, whether they will extend beyond 2013 and whether money can be raised now to buy peripheral bonds in markets deemed dysfunctional. This might soon push Europe further towards a single borrowing vehicle as a prelude to closer political integration and subsidiarization of sovereign fiscal autonomy.
Building confidence in these backstop mechanisms is a necessary but not in itself sufficient condition for restoring Europe’s government bond markets. All this will simply buy time for sovereigns to proceed with their annual deficit and structural debt reduction plans and, the optimists hope, demonstrate they can achieve these inherently unpopular measures while not destroying economic growth. Whether several European governments can achieve such large fiscal consolidation, all at once, without triggering recession has always been the far bigger and more important question than the form of the EFSF or the ESM.
