August saw big moves in bond yields - and Ireland was a winner

ECONOMICS:SUMMER IS now the favourite time for a crisis, a fact European politicians learned the hard way as their holidays were repeatedly interrupted in August.

In pre-euro times the focal point of such crises was exchange rates; now it is the interest rates at which governments can borrow – ie the yield on bonds issued by governments.

In this respect, August saw greater movements in 10-year benchmark bond yields than most of us can remember.

There were winners and losers but, for a change, Ireland fared best with bond yields falling from a peak of 14.6 per cent to 8.6 per cent, a much greater fall than in any other country.

This left yields back where they were last February, and made Ireland the best performing bond market over the summer.

The most recent phase of the crisis began on July 5th when Portugal was downgraded to junk status by Moody’s rating agency and the cost of borrowing jumped by two percentage points overnight.

Ireland was immediately in the firing line, and a week later it was our turn to be downgraded.

At the same time the first signs of distress in Spain and Italy became evident, with their bond yields rising above 6 per cent as the crisis spread from the periphery to the core.

An emergency summit of EU leaders was hastily convened, and its decisions on the bailout interest rate terms and mechanisms on July 21st saw yields fall sharply in Greece, Ireland and Portugal, but provided only temporary relief for Spain and Italy.

Within a few days Spanish and Italian yields were back at crisis levels on concerns that the size of the bailout fund was insufficient.

The antics of Italian prime minister Silvio Berlusconi, who was having public disagreements on policy with his finance minister, did not help.

Something had to be done and the ECB came to the rescue, but not before forcing additional budget austerity on Italy and Spain, an unprecedented move for a central bank.

France, fearful that it too might get caught in the maelstrom, announced its own fiscal package.

On August 8th, immediately after these developments, the ECB started to buy government bonds on the secondary markets. This was a controversial decision as it is barred from lending to governments, but it justified the move on the grounds that it was correcting disorderly markets. The impact on Spanish and Italian yields was immediate.

It is clear that the ECB objective was to lower yields in these two countries to 5 per cent.

It is buying their bonds at prices which equate to a 5 per cent yield, and the accompanying chart shows that it stuck rigidly to this policy, albeit with some slippage evident in recent days.

These two countries are thus in intensive care, and the ECB wishes to exit this programme next month when the EU’s rescue fund, the EFSF, is slated to take on this task.

Greece was a major beneficiary from the mid-July summit but all the gains were subsequently unwound. This, in turn, reflects a fear that the second Greek rescue package is falling apart as Finland and a number of others are seeking collateral for their loans to Greece, which the Greeks are unable to provide.

Portugal and Ireland were also significant winners from the summit as the cost of the bailout funds was slashed. Given their relatively more favourable fundamentals, this puts them in a more sustainable position.

It is clear, however, that the ECB has not been making a market in Irish or Portuguese bonds in the same way as for Spain and Italy.

Portuguese and Irish yields had fallen to 11 per cent before the ECB operation but have diverged dramatically since then.

Irish yields are now two percentage points lower but Portuguese yields are still around 11 per cent and are fluctuating to a much greater extent than those in Spain and Italy. Clearly the ECB is differentiating between countries and its main focus is on Spain and Italy.

The fall in Irish yields is by far the most dramatic change that has occurred, although it still leaves us a distance above the 5 per cent level that is regarded as appropriate for Spain and Italy, and even further away from rates of below 3 per cent for borrowing by France and Germany.

The differential with Portugal indicates that Irish yields have been driven down by private sector purchasers of its bonds. This is likely to have come from hedge funds and the like. There have been reports that the banks invested some of the new capital they received in July in government bonds but this has been downplayed by the Minister for Finance.

Overall, it reflects a significant reappraisal by the market and follows private sector investment in Bank of Ireland and more favourable external reviews.

Unlike Italy, France is not taking any chances. On August 24th, it announced an additional €11 billion of measures for 2012. Its fiscal consolidation effort next year will be 1.6 per cent of GDP, greater than any other euro country except Greece, Italy and Spain. Its reward was to see its cost of borrowing track Germany and fall below 3 per cent.

The French experience is most illuminating. Significant fiscal action was taken to head off the bond market vigilantes while others were forced to go back to the well and cobble up extra measures under duress. Apart from Germany, Ireland was the only country not to announce further fiscal measures in recent months.

While we have had a good summer, the moral of the French experience should not be lost on us. Ireland cannot afford to miss any of its fiscal bailout targets. Our interest rates are still at levels that are unaffordable and need to fall to 5 per cent before we can return to the markets in 2013.

As the ESRI has suggested, some insurance by frontloading measures slated for the 2013 and 2014 budgets would not go amiss.