Portugal: Growing Anxiety Over Government Bond Yields

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Summary

Despite the already significant increase in the Portuguese government bonds, I see no reason to bottom-fish here.

Portugal dismal public finances, the unsolved problems in the banking sector and the ECB reaching the limit of Portuguese debt purchases should push the government bond yields higher.

The acceleration of inflation in the Euro-Area and the elections in France and Germany, also point towards further increases in Portugal government bond yields during 2017.

Previous Reviews

In December, I shared my last outlook about the Portuguese Sovereign Debt. At the time, I mentioned that the Portuguese (NYSEARCA:PGAL) bond yield increases and credit spread widening were (and still are) passing relatively unnoticed to most market participants and that mass media was (and still is) mostly silent about it. However, I also said that the lack of bad news is not necessarily good news and that investors should avoid the temptation to buy these bonds.

I supported this guidance with the dismal state of the Portuguese public finances and the anti-austerity path that was being followed since the new Government took charge slightly over a year ago. Furthermore, I alerted the problems in the banking sector were being postponed (just like most Government current operating expenses) into 2017 so that they wouldn't affect 2016's deficit. Finally, I warned that Portugal was going to be the first country to reach the limit of purchases by the ECB in its PSPP (Pictet expects that will happen by June 2017).

What Happened Since Then?

In January, yields rose in every maturity past the 2 year period, steepening the yield curve.

Source: Investing

For example, the 10 year Government bond yields are now at 4.18% and today they even reached 4.235% (the highest level since March 2014). That's 40 basis points more than in December 22nd, when I wrote my last article and when yields were below 3.8%. In other words, that's a 4% decline in the price of these bonds in only 1 month.

Source: Investing

Since my last review, the Portuguese 10 year government bond yield spread over German bunds with the same maturity rose 12 basis points from 3.53% to 3.65%. This means that most (28 basis points out of 40 basis points) of the increase in the Portuguese 10 year government yield in January was due to the increase in the risk-free rate in the Euro-Area (the German Bund).

Source: YCharts

Major Threats Ahead

In my last article I mentioned 3 country specific reasons that will contribute to the increase in the Portuguese government bond yields in 2017: the terrible shape of the country's public finances, the unsolved problems in the banking sector and the ECB reaching the ceiling of Portuguese debt purchases. These 3 factors will translate in an increase of the Portuguese government bond yield spread over German bunds in 2017.

Today, I'll cover 2 other factors that will also push the Portuguese government bond yields higher: the rise in inflation in Germany and the French and German elections in 2017.

Inflation In Germany Is Already Close To The 2% Target

Today, Germany printed a 1.9% inflation rate for the month of January, the highest level since mid-2013. That's also an acceleration from the 1.7% registered in December 2016, clarifying some doubts over whether December figures was an outlier or not.

Source: Trading Economics

In the Euro-Area, the inflation rate increased to 1.1% in December and even though the figures for the current month are not out yet, the consensus estimate is for a 1.4% inflation rate in January, showing that the inflation is accelerating in most Euro-Zone countries.

Source: Trading Economics

Here, I must remember that the ECB aims at an inflation rate of below but close to 2%. So, these last numbers in Germany in particular and in the Euro-Area in general put pressure over the continuation of the monetary stimulus by the ECB. In fact, it makes no sense that the German 10 year bunds yield less than 0.50% when the inflation in the country is running at 1.9%.

As a consequence, bond yields across all Euro-Area countries have been rising since the summer of 2016. With no surprise, the European periphery has been the most affected as it is the most dependent on the ECB bond purchases. As the Greek sovereign debt is not part of the ECB purchases (due to rating constraints), Portugal is the most dependent on the Central Bank life-line support and as a consequence the nation bonds will remain under pressure as inflation accelarates in the Euro-Area.

Looking forward, a weaker Euro and higher oil and commodity prices from a year ago will contribute to push inflation above the 2% ECB target in the 1st half of 2017.

Source: Trading Economics

Source: Trading Economics

As a side note, I must say that the Euro-Area inflation is the bad kind of inflation any country should try to avoid. In fact, it is mostly due to the currency devaluation, to the increase in the price of imported goods and to a big dose of money printing by the Central Bank. It is not due to a stronger economy nor to an increase in internal demand. This means that Europeans are loosing purchasing power to the rest of the world. It also gives strength to Alan Greenspan argument that the World economy risks entering a period of stagflation.

European Elections In 2017

The other major threat for Portuguese bonds is the coming elections in France and in Germany in 2017. These 2 countries are the pillars of the Euro-Area and both were determinant in stabilizing the European sovereign debt crisis (even if they were unable to solve it). However, as the Brexit vote in the UK and the election of Donald Trump in the US remind us, politics can change 180º from one day to another.

The problem is that the major impact of a populist election in France and/or Germany will be felt the most by the European periphery and not by the center. As an example of the impact an election in a strong country can have on a weaker neighbor, look at the Mexican peso performance against the dollar during the US presidential campaign and after the election of Donald Trump.

In the Mexican peso, the adjustment was mostly made through the currency and only a bit by an increase in bond yields. However, in the Euro-Area, where most countries share a common currency, there's only 1 way to adjust for a bigger political risk and that is sovereign bond yields. This will add pressure and increase the spread between Portuguese government bonds and German bunds during 2017.

In Summary

Despite the already significant increase in the Portuguese government bonds, I see no reason to bottom-fish here. In fact, whether it's the country's terrible public finances, the unsolved problems in the banking sector, the ECB reaching the limit of Portuguese debt purchases, the acceleration of inflation in the Euro-Area or the elections in France and Germany, everything points towards further increases in yields during 2017.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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