PIIGS are flying and that bodes well for rupee

Yes, the unthinkable-at least that is what the markets believed-has happened. Bond yields of Portugal, Ireland, Italy, Greece and Spain have fallen dramatically over the last three years and the beginning of 2014 is seeing a surge in demand for bonds of the PIIGS countries.

Ten-year bond yields of Portugal, Ireland, Italy, Greece and Spain are trading at levels of 5.4 percent, 3.5 percent, 3.9 percent, 7.70 percent and 3.80 percent levels, respectively. Bond yields of these countries were trading at levels of 15 percent, 11 percent, 7 percent, 18 percent and 7.5 percent a couple of years ago as markets dumped the bonds on fears of debt default. Prices of bonds have an inverse relation with their yields. In other words, price decline when the yields go up and vice-versa.

[caption id=“attachment_1220483” align=“alignleft” width=“380”]  Representational image.
Reuters[/caption]

Portugal, Ireland and Greece went in for bailouts from the European Union to tide over the debt crisis while Spain went in for bank bailouts. All the countries are adopting austerity measures to bring down fiscal deficits. Greece is the one single PIIGS country that has not fully followed the path of the bond yields of the rest of the countries but that is due to the huge debt problems faced by the country.

More from Economy

Inflation likely to be a big focus area for budget 2024, say sources Explained: Will the Bank of Japan break tradition and raise interest rates?

Does the sharp fall in bond yields of PIIGS suggest that these countries debt problems are over? Not in a long shot as these countries still have huge levels of debt that will come down only on sustained austerity coupled with economic growth. Portugal has a debt level of 125 percent of GDP and growth was 0.2 percent in the third quarter of 2013.

Ireland debt level is 117 percent of GDP while growth was 1.5 percent in the third quarter of 2013. Italy has a debt level of 127 percent of GDP with zero percent growth, while Spain has a debt level of 86 percent of GDP and growth 0.1 percent. Greece has a debt level of 156 percent of GDP and growth is (-)3 percent.

The debt levels of PIIGS countries and their GDP growth do not warrant a steep fall in bond yields of these countries. So why are the bond yields falling sharply? One reason is that the ECB (European Central Bank) is keeping policy rates at 0.25 percent and banks that are flushed with central bank liquidity are buying into higher yields offered by PIIGS countries.

In fact, German ten-year bund yields have risen from lows of 1.2 percent to levels of 2 percent over the last couple of years. German yields have risen as banks and investors sold off low yielding bunds to get into high yielding bonds.

The question is how long will this declining trend in PIIGS bond yields continue? Given the spread between German bunds and bond yields of Ireland, Spain and Italy are at levels of 150bps to 180bps, the markets may still play for a narrowing of the spreads. This is because the 0.8 percent inflation in the Eurozone is well below the ECB’s threshold levels of 2%. The policy rate here is expected to stay at 0.25 percent levels.

The implications of falling bond yields of PIIGS countries are felt in the markets’ risk appetite. The euro that had tanked to the levels of $1.2 from levels $1.4 over a period of two years has gained 13 percent from the lows on the back of falling bond yields of PIIGS countries. Equity markets in the US and Germany are trading at record highs on the back of money flow into risk assets.

The risk appetite of markets will start feeding into higher yielding emerging market currencies such as the rupee (INR) that has fallen over 30 percent over the last few years. The differentials of 7.5 percent between the US, Eurozone and Indian policy rates present a strong case for buying into the Indian markets.

As PIIGS fly, the rupee will benefit. However, watch out for a sustained reversal of trends in PIIGS bond yields, as this would be a sign of risk aversion.

Arjun Parthasarathy is founder Investors are Idiots.com and INRBONDS.com. Follow him on twitter @arjunparthasara