Both Ireland and Portugal are having bond auctions this week. You know what that means – potential spikes of volatility! How will the markets react? Will we see the return of risk aversion?
But first, let’s have a quick refresher course on bonds! It is, after all, the start of a new school year. So what better way to get back into the collegiate mindset than by doing some review, right?
Government bonds are debt securities issued by national governments that can either be denominated in local or foreign currencies. Some examples of government bonds are US Treasuries, German bunds or British gilts (how they came up with these names, don’t ask me).
How do bonds work? A bond is basically a loan to the government. Let’s say you purchase a 10-year, 10% Treasury bond with a principal of $1,000,000. What this means is that you are essentially lending the US government $1,000,000 and will be paid interest 10% ($100,000) every year. Also, at the end of the 10th year, you’ll get the principal ($1,000,000) back. Pretty neat eh?
What makes government bonds so attractive is that they are considered “risk-free”. How come? Well, a government can always just print more money to help pay off their debt. The problem though is that there still exists the possibility that a country defaults. This means that it may be unable to pay back the money it owes.
This is what makes this week’s auctions so interesting. Over the weekend, our fellas over in Dublin scrambled to put out the fire in the financial markets sparked by talks of Ireland asking for more money from the IMF and the EU. In fact, rumors of the debt-stricken country needing another bail-out were so intense that Irish Finance Minister Brian Lenihan himself had to make a public announcement just to deny them.
According to him, Ireland had been granted enough moolah to last until 2011, but I don’t think that was enough to calm investors and take away their debt-induced goose bumps.
Proof of this is in the yield on 10-year Irish bonds, which hit a record-high at 6.5% before closing at 6.45% yesterday. This equates to an almost-4% difference to the interest rate of 10-year German bunds (considered to be the “safest” in the euro zone hood) which is capped at 2.46%. The difference implies that investors are getting a little more nervous about placing bets on Irish bonds. Yikes!
Furthermore, it’s not only Ireland that hasn’t been gettin’ any love from investors. Yesterday, the yield on 10-year Portuguese bonds tapped its highest rate since 1997 at 6.36%.
With Ireland’s bond auction scheduled today and that of Portugal on Wednesday, we could be in for a topsy-turvy ride on the charts. I do believe that the results of these auctions could have a serious impact on sentiment towards the euro. How, you ask?
A successful bond auction could lead to increased confidence among traders towards the euro zone debt situation and consequently lead to a euro rally. This is the likely scenario, as previous bond auctions have been pretty successful.
On the other hand, in the event of an unsuccessful auction, what currency do you think stands to benefit the most? Normally I’d say the dollar, but with all this talk about QE2 and deflation in the US, I don’t think that will happen. A more appropriate “alternative” currency for the euro right now is the Swiss franc. Even though the SNB came out with a pretty pessimistic statement in its last interest rate announcement, the Swiss economy is faring much better than the euro zone’s. A fall in confidence towards the euro could lead to an inflow of capital to Switzerland, and consequently lead to a drop in EURCHF.
In any case, it would be best to keep an eye out for the results of the upcoming bond auctions and their corresponding effect on price action. They may just dictate how the euro will trade all week! Stay sharp, folks!