Spanish Yield Curve – A loud whisper?

With ZIRP and LTRO it is hard to get a good read on the Spanish yield curve and what anything means.

Spanish 10 year yields have risen 9 days in a row, 5 year yields have moved higher 8 out of 9 days, and the 2 year has been much more mixed, until recently.

The 2 year yield is out 19 bps in those 9 days, but 18 bps of that move has occurred the last 2 days.  The 2 year bond fits the sweet spot of LTRO, is likely to be held by banks in non mark to market accounts, so it has been stable, but it has even started to leak a little.  The move is small, almost trivial, yet with all the things working to support 2 year bonds, it is curious that it is able to widen at all, let alone 18 bps in 2 days.

 The 10 year yield is 48 bps higher, but the 5 year yield is 54 bps higher.  The curve is still steep, but we are starting to see yields moving faster in the 5 year than in the 10 year.  In the past 5 days, the 5 year yields have underperformed the 10 year by 7 bps.  At the risk of making a mountain out of a mole-hill, this is worth watching.  The move started with the entire curve steepening.  So the move was bearish, but more isolated to the long end.  The move is starting to impact the “belly” of the curve more.  In a normal world, this small “flattening” of 5’s/10’s would be easy to ignore, but in a world where the curves are influenced (manipulated) by government policies that do everything possible to keep the front end anchored, this move may mean far more than it normally would.

We have been watching Spain for almost 2 weeks as a potential canary in the coalmine, and it seems in the past 2 days it has hit everyone’s radar.  I wouldn’t be surprised to see some ECB buying to keep the move in check, but with a pretty bloated balance sheet and a lot of disagreement over the ability of the ECB to shield its bond holding from restructuring, they might not be so willing.

In an effort to dig deeper into Spain, while the 10 year will still be a focus, the “flattening” and “front end” will be the next canaries as to just how bad this can get.  Small moves there are far more important than they seem because it means they are moving in spite of low rates, ECB purchases, LTRO, t-bill auctions, etc.   It seems strange that small moves there could be the most important clue for how bad this can get, but when we first started noticing that Spanish 10 year yields couldn’t hold onto gains on any day, it also seemed far-fetched to a lot of people that Spanish yields would be in the spotlight again.

Pain in Spain is very negative for the Euro. 

Expect talk of PSI and debt restructuring to increase.  There is only one way for sovereigns to get their debt down quickly.  That is to pull a PSI and make banks and insurance companies take the hit.  I would avoid European bank shares here, as their equity market cap and ability to absorb losses will be a tempting target for politicians who want to reduce debt and don’t want to waste a year making things worse, like Greece did.  This is especially true with LTRO reducing funding concerns.