European Yield Barometer Tainted by ECB

Over the past week, the yield on ten-year Spanish debt dropped from over 7.00% to a low of 6.60%.  The yield on Italy's debt dropped from over 6.00% to 5.78%.   That is great news, right?  It means that Europe has finally taken meaningful steps to resolve the debt crisis.  Not quite.

ECB Plan Temporarily Affecting Yields on Sovereign Debt

The yield on risky debt is normally an accurate, unbiased, and timely measure of default risk, which is why I have discussed the yields on Spanish and Italian debt several times in past posts.  Unfortunately, those yield levels are not currently true measures of default risk.

The ECB has floated a conditional plan that would potentially allow it to purchase the debt of member countries that were in danger of losing access to the capital markets at sustainable yield levels.  This plan may or may not ever be implemented. Even if it were implemented, it would not resolve the fundamental problems in Spain or Italy.

In addition, the ECB does not have sufficient funds to hold yields below economic levels for long; however, strategically purchasing bonds on the margin would artificially depress yields and inflate bond prices for a period of time.   In fact, even before the ECB purchases a single bond, the potential for future ECB purchases artificially reduces yield levels.  That is what we are seeing now.

The yields on Spanish and Italian debt are no longer pure measures of default risk.  Instead, they are being unduly influenced by the continuously changing probability of the ECB making short-term, non-economic purchases of debt sometime in the future.  As a result, when the yields in Spain and Italy decline, as they have over the past week, we cannot attribute that decline to reduced levels of default risk.

However, if and when Italian and Spanish yields were to return to over 6% and 7%, that would mean the true level of default risk would still be in the danger zone, even including the artificial influence of the ECB plan

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Brian Johnson

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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