What’s Really Changed?
By Zach Berg, CFA
April 30, 2012
To put it simply, Treasuries were a bit of a rollercoaster last week; they rallied Monday, had a prolonged selloff on Tuesday and Wednesday, changed course with a rally on Thursday and then remained flat on Friday to end the week effectively unchanged. The choppiness we saw last week is not attributable to only one factor, but rather is a mixture of domestic and international economic factors mixed with commentary from various international monetary authorities. Monday’s rally revolved around the concerns that Spain’s deficit will pose a contagion threat to the ongoing Eurozone sovereign debt crisis as the country continues to face ever-increasing borrowing costs. Tuesday saw a slight reversal, after Spain was able to sell �1.9 billion short-term debt, helping to assuage some fears in the region. The selloff in Treasuries that day came despite weak economic data here in the U.S. in the form of anemic durable goods orders that missed expectations; headline -4.2%, ex-transportation and ex-air -1.1% and -0.8% respectively. Wednesday’s selloff revolved around the Federal Open Market Committee’s (FOMC) latest minutes which highlighted the ongoing need to provide accommodative monetary policy due to ongoing headwinds facing the U.S. economy, which led some market participants to believe that further Quantitative Easing (QE) may not be off the table. Thursday, the Treasury was able to sell $29 billion of 7-yr notes at a record-low yield of 1.347%, beating expectations for 1.357% on a strong bid-to-cover ratio of 2.83. Friday morning, S&P downgraded the sovereign credit rating for Spain by two notches to BBB+ on growing concerns that the country’s debt could continue to rise in conjunction with weak economic growth and high unemployment. The ratings agency’s primary concerns were, “The deterioration in the budget deficit trajectory for 2011-2015, in contrast with our previous projections” and “the increasing likelihood that the government will need to provide further fiscal support to the banking sector”. Helping calm the markets, Spanish Economy Minister Luis de Guindos commented that when it comes to bailing out the country’s banks and financial institutions, “We don’t need it”. After all this back-and-forth, “risk on” then “risk off”, Treasuries finished the week little changed: 2-yr -.6bp (0.257%), 5-yr -1.7bp (0.825%), 10-yr -2.8bp (1.934%) and the 30-yr long-bond -.16bp (3.122%). What’s really changed? The European debt crisis continues to lead market sentiment towards “risk on” or “risk off”, we still know that the Fed remains committed to provide accommodative monetary policies due to mixed economic data here in the U.S. and it appears we could have a continued run of “business as usual” until something unexpected comes along.
Spain in Distress
A very interesting note out of the Bloomberg on Thursday highlighted the potential implications for Spain’s credit rating given the current level of the country’s Credit Default Swap (CDS) contracts. Their unique process begins by calculating a composite credit rating for each sovereign issuer that is based on the average ratings provided by the three primary ratings agencies (Moody’s, S&P and Fitch). A score of 1 indicates the highest rating across all three agencies and a score of 10 or less indicates an investment-grade rating. Spain’s current composite rating of 6.3 is equivalent to an ‘A’ rating by S&P. Across the horizontal axis in the chart below is the cost of a 5-yr (CDS) contract, which is the amount that traders are willing to pay in basis points to protect �10 million the country’s debt against a default. For example, a quoted price of 100bp would indicate a yearly premium or cost of �70,000 per year. To summarize, moving up and to the right indicates that a country’s debt is perceived as riskier, while moving down and to the left indicates a less-risky profile. The current cost of protecting Spanish debt for 5-years rose to 475bp, which Bloomberg indicates is more than 200bp higher than Turkey, which is below investment-grade according to the composite ratings. The CDS-Implied rating on the country could potentially place the investment-grade status of Spain at risk going forward. Early Monday morning, S&P placed a large number of Spanish banks on review for potential downgrade after the country reported that GDP shrank for a second consecutive quarter, marking its second recession since 2009.
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