- Markets were unimpressed by recent pronouncements that the worst was over
- The eurozone crisis enters more dangerous phase with attention focused on Italy and Spain
- Credit strategist says Spain has policies making it difficult to grow out of problems
The sleeping eurozone crisis reawakened this week.
Markets showed they were unimpressed by recent pronouncements by European politicians that the worst was over by pushing Spain and Italy's borrowing costs towards levels that prompted bailouts for other peripheral eurozone countries.
This promises to be one of the more dangerous phases of the crisis with the attention firmly focused on Italy and Spain, the eurozone's third and fourth-largest economies.
Madrid in particular finds itself in a tight spot with its benchmark 10-year bond yields hitting 6 per cent on Tuesday for the first time since November.
Investors were spooked by the admission in March that Spain would breach its budget targets for this year. However, they also fret that the deeper austerity, announced over the Easter weekend by the government, will push the country further into recession and maybe even spark social unrest.
"In essence they have policies that make it difficult for them to grow out of the problems," says Jim Reid, credit strategist at Deutsche Bank. "They are between a rock and a hard place."
More broadly there are worries from many investors that markets, after turning a blind eye to some problems in the eurozone amid the general euphoric start to the year, have finally woken up to them.
The rally in Spanish and Italian bonds during January was powered by the latest provision of central bank liquidity.
But the market is now subtly re-evaluating the European Central Bank's cheap three-year loans to banks, known as LTROs or longer-term refinancing operations.
When they were announced in December, their effects were at first largely ignored, but then they were described by many as a "game-changer" in January. Now the worries have resurfaced with a belief that they have done nothing to help the particular weaknesses in the eurozone.
"The idea that the LTRO solved all issues was just incorrect," says Nick Griffiths, head of global rates at Legal & General Investment Management. "For the markets it was a lifeline to give some breathing space but it did nothing for the fundamentals."
Although he expected Spanish yields to rise and was accordingly short on peripheral bonds, the timing of the move this week caught him somewhat by surprise.
With Spanish 10-year yields jumping 62 basis points in four trading days, he decided to cover some of his short positions on Wednesday. Others did the same which had the effect of suppressing yields which dropped 10bp.
The LTRO effect was so strong because it gave banks a simple domestic trade that looked potentially lucrative.
The ECB would lend banks money at 1 per cent which they could then invest -- particularly if they were Spanish or Italian -- in far higher-yielding domestic government debt.
Spanish and Italian banks duly did, snapping up local debt in record amounts. There were also clear signs of international investors selling out to domestic institutions.
For many this wave of domestic buying is a worry for several reasons. Most notably, the LTRO has reinforced the intertwined relationship between banks and governments. Banks, already laden with government debt, have taken on more, largely it seems in a bet that they would be in deep trouble in any case if there was a sovereign default.
Mr Griffiths says trading volumes were extremely thin in the past week and wonders how much the brutality of the recent move in yields can be explained by this.
"How much of this is due to it being Easter and the domestics not being there?"
But he adds that few international funds are invested in size in the peripherals while the LTRO effect appears to be wearing off: "Ultimately the market is only supported by domestics and they are running out of money so spreads can drift wider and wider."
That leaves the question of further central bank support. Benoit Coeuré, a senior ECB official, on Wednesday reminded markets that the central bank can directly buy bonds under its dormant securities markets programme.
But scepticism has risen this year among investors about the efficacy of the buying ever since the ECB managed to get itself excluded from Greece's debt restructuring.
Analysts at Citi point out that this means any restructuring in Ireland and Portugal -- the two other bailed-out countries -- could be even deeper as the official sector including the ECB will own a higher proportion of debt.
Another LTRO, however, remains a prospect that could deliver at least temporary respite.
"What we know now that we didn't six months ago is that the ECB have form in giving a massive response. There is no reason why we can't have LTRO 3 some time in the future. It won't solve the problem but it will ease it," says Mr Reid.
But many international funds remain nervous. Mr Griffiths notes that Spain has mostly issued shorter-dated bonds in recent months and still has half of its issuance to do for the year.
"It is hard to see how this gets better without another [flaring up of the] problem. It is an unstable equilibrium in the eurozone," he says.