Bond market mirrors a topsy-turvy financial world

Dan O'Brien

Economics Editor

JUST TWO weeks ago, an internationally respected economist – Dutchman Willem Buiter – caused a furore when he urged the Government to pre-emptively seek a second bailout. He offered this advice because he was utterly convinced that the State would be unable to tap the bond market in 2012.

What happened yesterday showed that two weeks is an eternity in the topsy-turvy world of post-Lehman international finance. Almost miraculously, the Government tentatively re-entered the bond market – and it did so on a day when the State handed over €1.25 billion to Anglo bondholders.

If the Anglo repayment caused revulsion, the willingness of private investors to increase their exposure to the Government is a cause of some wonder. It is, too, the best tangible sign that Ireland stands a real chance of exiting its three year EU-IMF bailout without resort to a second rescue.

If yesterday’s success for the money men at the National Treasury Management Agency (NTMA) was surprising, it can be viewed as the culmination of an astonishing narrowing of Irish government bond yields over the past six months.

As the chart shows, yields reached stratospheric levels last July. This led many commentators in Ireland and further afield to conclude that sovereign default was inevitable. Those voices are quieter now.

A large reduction in the interest rate for bailout funds, agreed at an EU summit in July, helped change sentiment toward Ireland and Portugal because it improved their prospects of repaying all their debts.

Adding to the momentum of the Irish bond market rally was stronger than expected economic growth in the first half of 2011 and revised statistics in September, which showed that Ireland’s balance of payments with the rest of the world had returned to surplus. Continued credibility-building endorsements from the troika helped too.

The Irish bond rally ran out of steam in October as it came up against the headwinds of the wider euro area crisis, illustrated in the chart by Italy’s five-year bond yield rising sharply.

The stabilisation of the euro crisis since December has been a relief, and much of it is is likely to be accounted for by the injection of almost €500 billion in cheap lending to the euro area banking system by the ECB last month.

Solid signs that the US economy is not slumping into another recession have also helped push down yields on most government bonds.

Of the relevant Ireland-specific factors, the high probability of some relief on the bank rescue component of the national debt is likely to have driven the fresh rally in the new year. That has brought bond yields back to levels that allowed the NTMA to test the market yesterday.

But not much is certain these days, and if financial markets have often appeared to over-react to events during the crisis, they appear to be under-reacting in recent weeks.

Almost every indicator points to a much weaker Irish economy in the second half of 2011, and growth prospects for 2012 are poor. Investors appear to be shrugging off these signs of weakness.

Across the Continent, the response to the underlying problems of the euro project remains woefully inadequate.

In the weeks and months ahead there are any number of potential flashpoints. One is Portugal. Yesterday, its government bond yields hit record highs, and the market is now pricing in a large risk of default. Another Greek saga playing out in Iberia hardly bears thinking about.

And then there is the likelihood that the real economy of Europe is contracting. British statisticians yesterday confirmed that their economy contracted in the final quarter of 2011.

Buiter is more likely than not to be proved correct in his view that Ireland will need a second bailout. But with so many factors determining whether that happens, and so much uncertainty surrounding each and every one of those factors, it could go either way.

All that said, yesterday’s return to the market by the NTMA is the most hopeful development in some time and one which increases the probability of avoiding a second bailout.