Italian, Spanish 5 year credit default swaps (CDS)

Italian five-year credit default swaps (CDS) tightened 0.19% in April while Spanish five-year CDS tightened 0.15% from 1.05% to 0.90%, even though both counties still face serious economic difficulties. Spain still has a lot of external debt and employment growth is partially due to falling wages, creating another hurdle down the road. Italy is still in recession and has official unemployment of 12.7%, with some unofficial estimates going even higher.

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ECB authority and Ukrainian volatility impact yields

“The tightening of CDS spreads, I believe is therefore driven by three factors,” writes John Brynjolfsson in the Armored Wolf LLC April letter to investors, a copy of which was reviewed by ValueWalk. John was PIMCO’s “lead expert on commodities and inflation-linked bonds” before founding Armored Wolf, says Jennifer Ablan of Reuters. He argues that the situation in Europe, “represents the building of an unsustainable bubble, which is not supported by fundamentals, so rest upon a foundation known as ‘the greater fool’ theory.”

First, the European Central Bank has established its authority to impose ad hoc solutions to sovereign debt crises over the last few years, which has improved periphery spreads across the board even though Ireland and Italy, for example, are on completely different paths financially. One of the lessons from the sovereign debt crisis has been a sort of Draghi Put.

Brynjolfsson thinks the tension in Ukraine plays a role as well because even the tail risk of an existential conflict has put more mundane discussions (pension liabilities, inflation on hold indefinitely, with the side effect of letting the ECB continue with its accommodative monetary policies unimpeded. While he doesn’t mention it, geopolitical tensions often cause a flight to quality that may be playing a role in falling bond yields as well.

Without QE, perhaps we may have seen double digit deflation: Brynjolfsson

“I am at a loss as to how, or why, profligate central bank money printing, and extremely low (or zero) funding rates has not induced inflation globally,” writes Brynjolfsson. “Without QE perhaps we’d have double digit deflation as companies and individuals were buried by bad debts.”

He floats a few theories as to why this might be (delivering private institutions, cheap money being used for speculation instead of productivity growth), but whatever the reason, Brynjolfsson sees the surprisingly low rate of inflation as another factor pushing periphery EU bond yields down. Eventually, there doesn’t seem to be any way around interest rates normalizing “necessarily and painfully,” but doesn’t hazard a guess as to when this might happen.