Economics 04/06/2010: Bond markets are still jittery

For all the EU efforts:

• Throwing hundreds of billions into the markets in bonds supports;
• Banning 'speculative' transactions;
• Talking tough on reforms;
• Bashing rating agencies into a quasi-submission; and
  
• Proposing a 'markets calming' [more like 'markets killing'] financial transactions taxes

There has been preciously little change in the way the bond markets are pricing sovereign debt of the PIIGS. More ominously, the crisis is not only far from containment, it is spreading. Following PIIGS, the attention is now shifting onto BAN countries - Belgium, Austria and Netherlands. And in the case of Austria, the unhappy return of the Eastern European woes is now seemingly on the cards.

How so? Look no further than Hungary. The country had taken IMF bailout money, promising to deliver severe austerity measures. It now faces a new round of pressures due to once again accelerating deficits. It looks like the cuts enacted were not structural in nature, amounting to chopping capital expenditure programmes rather than current spending... Sounds familiar? so here we go again (courtesy of Calculated Risk blog): spreads are rising (Ireland's position as the second sickest country by this metric remains unchallenged) and CDS rates are rising as well (Ireland's still in number 3 spot).
As Calculated Risk points: "After declining early last week, sovereign debt spreads have begun widening for peripheral euro area countries. As of June 1, the 10-year bond spread stands at 503 basis points (bps) for Greece, 219 bps for Ireland, 195 bps for Portugal, and 162 bps for Spain."

Let's get back to Hungary, though: yesterday, Hungarian officials said that instead of 3.8% of GDP deficit target, 2010 is likely to see the deficit widening to 7-7.5% of GDP. Who's to blame? Well, per Reuters report: '"fiscal skeletons" left by the previous Socialist administration'.

A tale of a missing bonds rally

US markets have seen some strong rally momentum in recent days. Here is a good piece on bond markets in the US.

"If there really are signs of financial recovery, nobody told the bond market. Treasury Secretary Timothy Geithner's plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from March 6 to an impressive 19% through Wednesday. But credit markets have hardly budged. Corporate debt is still priced for disaster... Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market -- the seat of the crisis -- it seems irrational to expect a durable move higher in equities."

Yes, pretty much on the money. Here's how the numbers work: in my post on personal income by states - California is overdue a democratic party payoff and it will come, so the municipals markets and TIPS are going to be a good bet for some time to come. But the stock market is running too hot on absolutely nothing new - US Treasury's latest plan is a net transfer to
shareholders, which, obviously, first reduces any possible haircuts for bondholders, thus giving a fundamentals support to bonds ahead of shares.

What does this mean? If shares rises in the last 20 days is justifiable by fundamentals, there
should be at least a noticeable rally in bonds (although not as strong as in stocks, since bonds have already priced in all seniority over equity, thus a boost to equity holders yields is not going to be translated into 1:1 gains on bond prices).

My estimate would be as follows: for a 19% rally in equities, were the new valuations to set a new 'floor', we we will see a 5-6% gain on equity yields (including cap gains) over the next 3 years.

This would imply a yield differential compression to comparable corporate bonds relative to underlying equity. Assuming average yield differential for equity relative to corporate bonds of 8-10% in favour of bonds prior to equities rally, our post rally differential is ca 7.5-9.5% range. So bond prices have an upside potential of ca 16%. This is just straight math.

Now, take a cautious assumption that a part of equity rally is due to a fall in the perceived risk of default on equities (the recovery rate priced in CDS stays put, but expected recovery rate rises). Say 1/2 of the rally is just that. Then, price upside on corporate bonds is in the regions of 8-11%, holding YTM fixed. Until we see at least such a movement, the equity markets are overshooting the floor. And they are doing so pretty dramatically.