The pain in Spain falls – but for how long?

Spanish bond yields continue to fall, plunging this morning to levels last seen in 2006, years before the crisis that dramatically increased the costs of borrowing for many riskier European governments.

(Tradeweb)

The yield on a 10-year Spanish bond dropped to below 3.7 per cent this morning, down from four per cent at the end of 2013 and slashed from the eye watering levels (over six per cent) seen before Mario Draghi’s “whatever it takes” speech in July 2012.

While bond yields in the US and UK climbed last year on expectations of tighter monetary policy, peripheral Europe has been partially relieved by a general decline in the cost of servicing new debt. Though Greek 10-year yields are still hovering above seven per cent, there has been a colossal reduction from 2011-12’s crippling highs.

But UBS Asset Management’s Joshua McCallum recently raised doubts about whether these debts are now properly priced, suggesting that peripheral countries will either need to increase their potential growth rate, start running a large primary surplus, or find a way to reduce their yields:

A combination of all three is likely to be most successful, but it will still take time. Most of the periphery has paused in both growth reforms and austerity. In those circumstances, are investors really wise to lend to them so cheaply?

McCallum ranks Spain as one of the less troubled peripheral nations, in terms of long-term issues servicing its debts, but leaves it firmly in the group of countries which are likely to have long-term fiscal issues:

The countries in the blue shaded area of the chart have the potential to outgrow their debt burden. The countries in the red shaded area, on the other hand, will be forced to borrow in order to meet their interest payments – which quickly becomes a vicious spiral as interest will need to be paid on this new debt.