The market reaction from the past few days brings back some memories of the Euro-zone debt crisis, when problems in a small country caused jitters across markets. However, there are plenty of reasons to argue, why this is not the start of another crisis.
Both Euro-zone non-core bonds and equities in general have a huge rally behind them, so it is not hard to argue that a correction and an episode of profit taking were overdue. This time, the triggers for that appear to have been uncertainty about the Q2 earnings season as well as worries towards the Portuguese banking sector, coupled with increased geopolitical tensions.
Plenty of risks still out there – markets much more resilient
There is no doubt that a lot of negative news is still lurking around the corner. The ECB’s upcoming stress tests only add uncertainty over the state of the banking sector over the coming months and the Portuguese situation is far from resolved. Still, the markets have become much more resilient towards negative news compared to just a couple of years ago. In the Euro zone, monetary policy is still being eased, and the increasingly low core bond yields force investors to look for return elsewhere. As the markets stabilize, the more attractive entry levels should thus look more compelling for establishing new long positions in non-core bonds.
As a result, even though market jitters may have some more to run in the very near future, there is still little reason to think that the recent events would mark a reversal in the recent trend of more positive risk appetite. Another major general sell-off in non-core Euro-zone bonds is not on the cards for now. That said, the bond markets have not stabilized yet, so the time for establishing new spread-narrowing positions is not here yet.
The recent moves are also healthy in a sense that they remind that there are risks out there and markets can move both ways. This also means that there are likely to be more bumps in the road for a further rally in non-core Euro-zone bonds and risky assets in general. Volatility has not disappeared for good.
Headlines bigger than actual market moves
Despite the scary headlines, the losses especially outside Portugal have been quite limited so far. The Italian 10-year yield has climbed by less than 15bp this week, and is around 25bp higher compared to the June lows. It remains more than 100bp lower compared to the start of the year. European equities (STOXX 600 index), in turn, have fallen by less than 4% from their recent highs, and remain higher than at the start of the year. Even in Portugal, the equities have fallen to levels prevailing last December, while the 10-year government bond yield has risen back to levels last seen in May.
What is really happening in Portugal?
The worries in Portugal have centred on the largest listed bank of the country by assets. The worries towards the bank really surfaced in May, when the bank announced an audit by the Bank of Portugal had found the parent company of the bank to be in serious financial conditions. Earlier this week, the worries mounted on the back of reports that the parent company had delayed interest payments on short-term debt instruments.
Bank of Portugal has tried to assure the bank remains protected despite the problems of its parents, while the bank has clarified its links to the parent. The IMF, in turn, put out a statement saying the Portuguese banking system has been able to endure the crisis without significant disruption, aided by substantial public capital support and extraordinary measures from the ECB. However, it addedpockets of vulnerability remain, warranting corrective measures in some cases and intrusive supervision in others. Also the IMF thus admits risks remain.
At the very least, the Portuguese case illustrates there are still vulnerable banks out there. More such episodes are likely to surface ahead of the ECB’s stress tests, but nothing that would bring us back to a wider financial crisis.
Nordea