Global markets cleared a crucial psychological hurdle early yesterday evening in their search for stability when Italian and Spanish bonds rallied strongly on the back of European Central Bank buying.
Yields on the debt of both countries fell by about three quarters of a per cent to less than 5.3 per cent in early European trading, a huge move. If sustained, it will buy the European Union more time to craft a stronger defence of the two nations, considered Europe's Maginot Line in the fight against sovereign debt contagion.
The European rally was reflected in Wall Street futures, where expected Wall Street losses were halved, albeit to a level that still showed a solid decline in the Dow Jones Industrial Average of 30 blue-chip US stocks.
Finance ministers in the G20 group also issued a statement declaring that they would take "all necessary initiatives in a co-ordinated way" to stabilise the markets and foster economic growth. But with the US sovereign debt ratings downgrade piled on top of Europe's problems the markets are still focused on short-term developments.
The European Central Bank support for the Italian and Spanish bond markets, for example, is mainly about sending a signal that the bonds were oversold and under-priced. Central bank buying cannot continue indefinitely - and one fear in Europe is that the ratings agencies will now turn their attention to another AAA European economy - France.
Another short-term hurdle was looming overnight in potential downgrades of widely-held US municipal, or local government bonds that are benchmarked against the federal credit rating that Standard & Poor's cut from AAA to AA plus on Friday.
Pimco, arguably the world's most influential bond investment manager, has told its clients, however, that the US government debt markets are "still the deepest and most liquid in the world."
America's obligation to service its debt is unaffected, the US Federal Reserve has told US banks that they do not need to support the downgraded US bonds with extra capital, and the US dollar and US government paper will "still be the reserve currency and the safe asset due to the lack of an alternative," Pimco said in note to clients.
Further out, the highest and most important hurdle looms - economic data that the US and Europe report in coming weeks and months.
The selloff was triggered in part by Washington's deal to increase its borrowing limit in return for spending cuts. But the key concern is that the fiscal screws are being tightened at the same time as US growth is turning down its rebound from the 2007-09 global crisis.
One hope is that weakness in the June quarter reflected a manufacturing supply chain interruption caused by Japan's earthquake and tsunami. But if US growth is as weak as feared, the options are limited.
The US government has agreed to cut spending, and the US Fed's key interest rate is already close to zero.
The Fed meets tonight, our time. But its willingness to launch Plan C - another round of quantitative easing - is going to be be tempered by the fact that even as the US economy struggles to grow, it is showing signs of reigniting inflation.
Frequently Asked Questions about this Article…
What sparked the recent rally in Italian and Spanish bond markets?
The rally was driven by European Central Bank (ECB) buying, which sent a signal that Italian and Spanish bonds were oversold and under-priced. Yields on both countries fell by about three quarters of a percent to under 5.3% in early European trading, giving the EU more time to craft a stronger defence against sovereign contagion.
How did the European bond rally affect US markets and investor sentiment?
The European rally was reflected in Wall Street futures, where expected losses were roughly halved, although forecasts still showed a solid decline in the Dow Jones. The improvement eased some immediate pressure, but markets remained focused on short-term developments like the US sovereign downgrade and upcoming economic data.
What are the implications of Standard & Poor’s downgrade of US sovereign debt for everyday investors?
S&P’s cut of the US sovereign rating from AAA to AA+ raised concerns about benchmarks that tie municipal and local government bonds to the federal rating. That created the risk of potential downgrades for widely held municipal bonds. However, notes in the article point out that US government debt markets remain highly liquid and the Fed has told banks they don’t need extra capital to support the downgraded bonds.
Why might ratings agencies turn their attention to France, and what could that mean for investors?
The article notes a fear in Europe that, after ECB intervention in Italy and Spain, ratings agencies could next scrutinise another AAA economy such as France. For investors this represents a potential risk to sovereign bond stability in Europe, so it’s a development worth monitoring rather than an immediate certainty.
How could a potential downgrade of US municipal bonds impact everyday portfolios?
Because many US municipal or local government bonds are benchmarked against the federal credit rating, a downgrade to the federal rating increases the risk that those muni bonds could be downgraded as well. That could affect value and demand for municipals held by retail investors and funds, so investors should be aware of benchmark exposure in bond holdings.
What role did the US debt-ceiling deal and fiscal tightening play in recent market moves?
The selloff was partly triggered by Washington’s deal to raise the borrowing limit in exchange for spending cuts. The key market worry is that fiscal tightening is occurring as US growth appears to be weakening after the 2007–09 recovery, which could limit policy options and weigh on markets.
Is another round of quantitative easing (Plan C) likely from the Federal Reserve?
The Fed was meeting shortly after these developments. While another round of quantitative easing (referred to as Plan C) is a possible tool, the article says willingness to launch it would be tempered by signs that inflation might be re-igniting even as growth struggles, so the decision is not straightforward.
What should everyday investors watch in the coming weeks according to the article?
Investors should watch upcoming US and European economic data, central bank actions (especially from the ECB and the Fed), bond yields, potential rating-agency moves, and the status of municipal bond ratings. These developments are the highest hurdles for market stability in the near term.
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