Bond markets show confidence in Europe

Europe's bond markets sent out a strong signal this week that the continent's debt problems are no longer the roadblock to recovery they once were.

Spain's first bond auction, in what will be a crucial year for the sovereign, passed without incident. In fact, the debt sale was about as good as can be expected, with the €5.82 billion raised comfortably above the €5 billion top-end of the target range. Yields were lower and demand was decent. Spain needs to find €71 billion over the course of the year, and this was a solid start.

The successful auction will probably dampen speculation that Spain will request a bailout this quarter. Ireland has already been rescued by its European partners. It has implemented the required austerity programme with vigour, and its economy has performed admirably in the circumstances.

Ireland's small, open economy and its large multinational sector means that GDP figures probably flatter the country - GNP is a more appropriate measure. Nonetheless, compared with the other peripherals its economy looks positively healthy.

The bond and CDS markets clearly agree - Ireland's CDS, at 185bps, trade considerably tighter than Spain, Italy and Portugal. Its auction of 2017 bonds this week met with strong demand from international investors and was another step towards normal access to the capital markets.

However, only the most myopic of investors would think that the eurozone's debt problems have been solved. Growth is nowhere to be seen and stimulus options are thin on the ground. The ECB's reassuring presence has certainly underpinned the recent rally, but the central bank cannot reinvigorate the region's economy when rates are close to zero.

Spain has managed to avoid asking for a bailout, so far, and this is in no small measure due to the ECB's commitment to intervene. But another peripheral country is in a far worse state, and served a reminder this week that the symbiotic relationship between sovereigns and banks continues to inflict damage.

Cyprus was downgraded to Caa3 from B3 by Moody's on Thursday, the agency citing the onerous cost to the state of recapitalising the country's banks. Moody's estimates that the bank recapitalisations will bring Cyprus's debt/GDP ratio to 150% in 2013 - a level that will be difficult to sustain. The sovereign's CDS widened 200bps on Friday to 1210bps.

Cyprus has already requested a bailout, but Germany and others in the eurozone are reluctant to agree. Cypriot banks are funded by deposits, with a large proportion from Russia. Germany is less than keen on using its taxpayers' money on bailing out such depositors.

It is possible that the EU will force depositors to bear some of the cost of the bailout, though this would be an unprecedented step for a European debt restructuring. The region's policymakers will have to balance the possible fear this could spread through the continent's banks with a moral argument for fairness. History suggests that Europe will err on the side of caution and open its chequebook.

Download full article