Olli Rehn’s Portuguese scare latest marker in ‘worrying trend’, says Lorne Baring

Lorne Baring, managing director and founder of B Capital says the turning point on renewed eurozone worries came as early as 2 March this year.

Yield spreads in southern Europe have collapsed as the ECB’s LTRO and economic recovery in the US economy have provided a backdrop for improved sentiment in the first quarter of 2012.

Italy, as the largest debtor nation in focus, has seen its 10 year benchmark bond yield drop by almost a third this year to a low of 4.79%, which demonstrates the market view that the pessimism in late 2011 was overdone.

The highest yield of 7.52% in November 2011 is still in investors’ minds however while doubts over progress within European economy remain.

Indeed the poor Spanish debt auction and hints of no further QE from the Federal Reserve minutes this week have sent the same Italian benchmark 10 year BTP prices plunging by -3.95% to give a yield today of 5.49%.

Portugal has been in focus as investors clash with policymakers over the ability of the country to roll over debt due in 2013. Whilst the ECB and Portuguese government maintain that the budget plans are on track to repair the country’s substantial budgetary deficit the bond markets have begun to question this prediction; Portuguese yields are rising and are now close to 12%, which is a worrying reversal of the trend in first part of this year.

Where was the turning point? We suggest that the return to Euro worries came on 2nd March this year when Mariano Rajoy, the new prime minister of Spain, announced that the budget-deficit target for the year was being thrown out of the window. Instead of a more palatable 4.4% of GDP he revealed that the new target would be a heavier 5.8% deficit.

The bond markets showed their distaste for the worsening picture of Spain’s public finances straight away. The next question for investors will naturally be about Portugal, which is suffering from much higher borrowing costs and now has to contend with its biggest trading partner breaking away from hawkish austerity plans this year.

Will Portugal break from its targets as well as Spain? If it does then investors will quickly shy away from its bonds and yields will spike once again. We forecast that it will be hard for Portugal to keep on track while Spain does not keep to its budgetary targets and that implies difficulty in refinancing debt maturing in 2013 without international aid.

This is a reminder that the European sovereign debt crisis has only been eased by liquidity measures in the short term while the real problem is one of solvency. Until the solvency of weak sovereigns is addressed the symptoms of higher borrowing costs will persist.

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