Spanish and Italian bond yields

Spanish and Italian 10 year bond yields have dropped by 76 and 61 bp respectively since the end of July, driven by rumours that the ECB will act to cap spreads against the equivalent German yields. The Bundesbank remains vehemently opposed to this idea and the ECB has denied the rumour but there is no smoke without fire as the saying goes. It may be that European policy makers are moving to transform the ECB into the mroe traditional and flexible central bank that it needs to be if there is to be any resolution to the ongoing euro crisis but there are many issues to be resolved if this is to happen. Given the glacial speed that European policy makers move at, it is more than likely that the crisis will reemerge yet again to be followed by more frantic meetings. Investors remain caught between two opposing outcomes. If the ECB monetizes, equities will rise and bonds fall; if it doesn't, we will have the reverse. The odds favour the latter outcome as Europe's track record is one of reacting to events by indulging in more bail-outs adding yet more debt to an over-indebted set-up and refusing to tackle the insolvency that plagues so much of Europe's financial system. That said, don't rule out some form of monetization. Global growth is weakening and the outlook for China is deteriorating. The pressure is on all central banks to indulge in some form of further QE and the ECB in particular as austerity drives so many of the PIIGS' economies into the ground. Perhaps there is more to the fall in Spanish and Italian bond yields than meets the eye.

Market falls

Equity markets have dropped by 3% in the last few days, or getting on for 5% if you include today's falls. The catalyst was last Friday's supposedly poor employment report in the USA and the announcement that China had a small trade surplus in March as opposed to the expected deficit. It is hard to believe either of these announcements were of world shattering importance albeit employment is a hot political issue in the US. Generally, most recent economic data has been on the positive side although lacking a bit of oomph. It is also worth noting that equity markets were overbought given the sharp rises in the first quarter of the year.

That said, there are one or two worrying developments. The first is widely predicted re-emergence of the Euro-zone debt crisis, particularly for Spain and Italy. The premium for Spanish 10 year bonds over German bonds peaked at 4.7% in November and then fell to 3.0% six weeks ago. It is now 4.3%. Those investors who thought they were going to make easy money out of LTRO may now be nursing some losses. The second development is the lack of any earnings growth by global companies. Although equity markets were looking cheap at the end of 2011, such arguments are less convincing now.

Although comment on the US employment report can look like a lot of hysterical hot air, it is quite possible that it is a proxy for more serious matters.