European Sovereign Spreads: Time to be cautious?
The chart here above illustrates the yield spread between the 10 years Italian BTP and the 10 years German Bund since 2010.
The incredible 2011 spike in the midst of the European Sovereign crisis is striking on the chart, especially when compared to the relatively quiet period experienced since 2014. Since the 2011 crisis the ECB has been very wary in order to prevent the market from becoming fearful again about Southern Europe (especially Italy, Spain and Portugal because Greece is a different story), either verbally with Mr. Draghi’s famous “whatever it takes” speech, or actively through the different asset buying programs they have implemented.
As a result, today’s Italian or Spanish spreads versus Germany are quite compressed and it seems difficult to imagine them getting much lower from here. As an example, Italy trades somewhere between 120 and 140 basis points higher than Germany today, which seems pretty low when taking into consideration the rating differential between both countries (BBB versus AAA), but even more so when looking at the absolute yield provided by the Italian 10 year BTP, roughly 1.2%.
When it comes to fundamentals, caution seems even more necessary: Italy’s debt to GDP ratio stood at 135% at the end of March this year, Spain’s at 101% whereas Germany’s ratio was 71%.
The trend calls for caution as well, because since the beginning of 2011 this ratio has gone from 115% to 135% for Italy, from 61% to 101% for Spain but has decreased from 81% to 71% for Germany. Forecasts for this year are not encouraging and the relative and absolute deterioration of both Italy and Spain’s fundamentals looks set to last.
The ECB can obviously act as a safeguard against any panic before the very important political events which are ahead of us, for example the Italian referendum in December this year, which will probably turn out to be a vote for or against the European Institutions. But can the ECB go very far in terms of spread compression? In other terms, can the European Central Bank decide to squeeze European spreads despite increasingly diverging fundamentals, and in any case would Germany accept it? We definitely doubt it and would once again reiterate our cautious stance on countries like Italy, Spain, Portugal and, to a lesser extent, France.