Posted by FT Alphaville on Dec 12 00:36.
Sovereign credit risk is not a subject that usually excites tabloid newspaper editors. Indeed, economic matters of any kind rarely feature amongst the scurrilous stories that dominate the front pages (The UK’s Sun newspaper managed to combine both in a cheeky headline on Tiger Woods). But this week the issue that has preoccupied investors took hold in the public discourse, and it can be expected to stay there for some time. A political budget in the UK and an austerity budget in Ireland crystallised the tough times ahead for citizens of both of these countries. Greece’s dire fiscal situation threatened to escalate into a full-scale crisis. The rating agencies flexed their muscles and made clear that government must take action to make their public finances sustainable.
All of this spilled over into the credit and equity markets. Investors became more risk averse, with many fearful of a contagion effect. But the widening in the corporate CDS market was relatively tame, and the Markit iTraxx Europe index stayed below 85bp, close to its recent tight levels. Unsurprisingly, the Markit iTraxx SovX WE was a different matter. On Wednesday, the index widened to 70bp for the first time, and the differential between the iTraxx main and SovX was at its smallest since the banking crisis earlier this year (see chart). This reflects the current stage of the cycle; risky assets are benefitting from propitious market conditions, helped by governments running expansionary fiscal policies. Many of these countries entered the recession with less than stellar public finances, and are now suffering from large structural deficits.
The UK, Ireland and Greece all come into this category. The UK saw its spreads widen sharply earlier this week as the panic in Greece and the impending pre-budget report (PBR) rattled nerves in the markets. The PBR itself was something of a damp squib as it was heavily trailed in the press. Many considered it timid and too concerned with drawing Gordon Brown’s famous dividing lines with the opposition. But the report still implies drastic public spending cuts if the deficit reductions are to be achieved, and that’s assuming Alistair Darling’s projections for growth and tax revenues are achieved. Spreads have actually tightened in the latter half of the week after the PBR, perhaps reflecting market confidence that the cut-thirsty Conservative Party will be elected in the Spring.
The Irish government was fortunate not to have worries about an impending election, and took full advantage in its budget on Wednesday. Finance Minster Brian Lenihan laid out savage spending cuts, with public sector workers bearing the brunt (including the Taoiseach and the cabinet). The radical action was welcomed by the markets, and Ireland’s spreads have regained much of their widening in the run-up to the budget. However, its problems are severe and investors will be watching for signs that the situation is deteriorating.
That scenario can certainly be applied to Greece, the black sheep of the eurozone. Its spreads have widened sharply this week, assisted by negative rating agency actions. The senior members of the EU have rallied around the beleaguered nation, stating that they would stand behind it and prevent default. The ECB was more less confident, and markets remain unsure. Greece’s spreads tightened after the announcements yesterday and today, and signs that the government is finally recognising the seriousness of its situation have been welcomed. But its situation remain precarious and it is still the sovereign most likely to scupper any year-end rally in credit.
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