Spanish and Italian borrowing costs sank again on Tuesday even though there is little compelling evidence that Spain is on the verge of a quick rebound and zero evidence that a fix will be found any time soon for Italy's deep recession and political fragility.
The yield on 10-year Spanish bonds fell five basis points to 4.03 per cent Tuesday, taking the one-year fall to 161 points (100 basis points equals one percentage point). That's the biggest drop among the large European Union countries. Spain's "spread" – or yield difference – over equivalent German bonds is now 230 points, the narrowest in more than two years.
Italy's 10-year yields also fell by five basis points to 4.14 per cent, for a one-year fall of 87 points. That level is high compared to the pre-crisis years, but low enough for the coalition government of Prime Minister Enrico Letta to claim that the worst of Italy's debt crisis is well gone. The Italian treasury is to sell a much as €6-billion ($8.6-billion) of five- and 10-year bonds on Wednesday.
Spain's good bond performance is partly to do with bond redemptions, which provided liquidity that was, apparently, plowed back into bond purchases, and partly to do with encouraging, if not stellar, economic data. On Tuesday, Spain's national statistics office reported a 2.2-per-cent rise in retail sales in September, year on year, after a 4.4-per-cent fall in August.
The Spanish economy is out of recession, but only barely, and economic recovery is expected to take many years. The International Monetary Fund does not expect Spanish unemployment, at 26 per cent, to fall below 25 per cent until 2018 because "the weak recovery will constrain employment gains."
So how do you explain the falling yields in two countries that remain economic laggards?
The European Central Bank is still working its magic, to be sure. Fifteen months ago, ECB president Mario Draghi promise to do "whatever it takes" to contain the debt crisis, ensuring that none of the bailed-out countries would bolt from the euro zone. To do so, the ECB would buy unlimited amounts of the bond of any country that had trouble financing itself. The so-called outright monetary transactions (OMT) program has never been used by the ECB, but its mere presence has scared off the bond vigilantes and restored calm to the bond markets.
Another reason appears to be that foreign investors have largely disappeared from the bond markets of the hardest-hit countries. The Financial Times on Monday reported that domestic investors in Spain and Italy, who are willing to settle for a lower risk premium than foreign investors, have bought almost all of their countries' debt issues this year. Their overwhelming presence has provided a stability that has not been seen since 2009, when Greece triggered the debt crisis. The buyers have been the banks that, laden with cheap ECB loans, have been loading up on Spanish and Italian debt. The bonds, in turn, are being used by the banks as collateral to obtain even more cheap ECB loans.
The danger is obvious. The link between the banks and their home-country governments is as strong as ever. If a fresh crisis erupts, and yields rise, both the governments and the banks would get into trouble. The former would face higher funding costs; the latter would be sitting on vast quantities of bonds with lower values. The pin has been put back into the sovereign bond grenade but the grenade is still there.