Draghi Safety Net Becomes Blindfold to Risk as Bonds Soar

By David Goodman  

Photographer: Ralph Orlowski/Bloomberg

Bond markets show European Central Bank President Mario Draghi’s July 26, 2012 pledge... Read More

Two years since European Central Bank President Mario Draghi’s historic promise to defend his currency bloc, there are signs bond investors are growing too complacent under his protection.
While Draghi’s pledge, backed up with unprecedented policy action, held the euro region together, recent price moves suggest it also immunized investors against risk. The average yield on bonds from Europe’s most-indebted nations touched a record low yesterday, even after the downing of a passenger plane over Ukraine, an escalation of conflict in Gaza and financial woes at Portugal’s Espirito Santo Group.
“It’s been an exercise in central banks desensitizing markets,” Marc Ostwald, a strategist at ADM Investor Services International Ltd. in London, said in a July 23 phone interview. “It’s a dictated complacency because globally there is a huge amount of liquidity. Everyone views everything as a localized problem.”

Bond markets show Draghi’s July 26, 2012 pledge to do “whatever it takes” to protect the euro was the turning point in the region’s debt crisis. The day before the message, delivered in a speech in London, Spanish 10-year (GBTPGR10) bond yields had surged to a euro-era record 7.751 percent, above the 7 percent level that pushed the Greek, Irish and Portuguese governments to seek international aid.

ECB Stimulus

Those words, which were followed with an emphatic “and believe me, it will be enough,” and backed up with a series of unprecedented stimulus measures from the ECB, fueled a rally in the bonds of Europe’s most-indebted nations that cut Spanish 10-year borrowing costs to a record 2.529 percent and allowed Greece, Ireland and Portugal to regain access to capital markets.
The force of the rally, and belief in the power of central-bank support, is such that it has continued in the face of this month’s geopolitical and financial shocks. The turmoil in markets was contained by a stimulus package announced by the ECB last month, which included charging lenders to park cash with it overnight and targeted cheap loans.

Yields Slide

Italian 10-year (GSPT10YR) yields dropped for the ten days through yesterday to 2.73 percent, the longest run since 2005, in a period which included the destruction of Malaysian Airlines flight MH17 and an Israeli military offensive into the Gaza strip. The U.S. says the Malaysian jet was probably downed by a missile fired from a Russian-supplied launcher, a claim denied by pro-Russian insurgents.
Portuguese 10-year yields have risen just four basis points, or 0.04 percentage point, to 3.69 percent this month even as two companies in the Espirito Santo group failed to repay short-term debt and sought protection from creditors.
The bonds were little changed as of 7:58 a.m. in London even after Espirito Santo Financial Group SA said yesterday it requested to be placed in the regime of “controlled management” under Luxembourg law.
The average yield to maturity on bonds from Greece, Ireland, Italy, Portugal and Spain fell to 1.8856 percent, the least since the formation of the currency bloc in 1999, according to Bank of America Merrill Lynch indexes. The securities have returned 0.5 percent in July, set for a 12th month of gains.

‘Least Resistance’

“We have been encouraged how the market has traded through the recent flare in geopolitics in the Ukraine and Gaza,” Russel Matthews, a money manager who helps oversee $67 billion at BlueBay Asset Management LLP in London, said in a July 23 phone interview.
BlueBay used the temporary jump in Portuguese bond yields in the wake of Espirito Santo’s financial turmoil to add to its holdings of the nation’s debt, Matthews said.
“The path of least resistance is for spread compression,” he said. “You could argue that complacency is building, but I don’t think that is a story for the immediate future. The most likely catalyst for a meaningful selloff is if central banks are forced to change tack.”
The muted reaction to financial shocks may also encourage governments to dial back their reform efforts to placate voters squeezed by higher taxes. After euro-skeptic and anti-austerity parties made gains in this year’s European Parliament elections, anchored bond yields risk encouraging beleaguered governments to put off plans to reform everything from public-sector wages in Portugal to the debt load in Italy. That would run counter to officials’ efforts to control sovereign finances and to avert the threat of deflation.

Catastrophe Averted

Although Draghi’s pledge may eventually create complacency among investors and governments, its success in preserving the currency bloc is far more important, according to Stuart Edwards, a money manager at Invesco Perpetual, based in Henley-on-Thames, west of London. The company is part of Invesco Ltd., which had about $802 billion under management as of June 30.
“There’s always a risk that these countries become either complacent, or there’s enough domestic political pressure brought to bear on them that slows the reform process -- or even reverses it,” he said in a July 22 phone interview. “But there was a far bigger risk before: the catastrophic result that would have occurred had the euro zone broken up; or if the status quo from a couple of years ago had prevailed.
‘‘It’s not perfect, but we’re in a much better position now than we were in two years ago,” Edwards said.