Liquidity in European Government Bonds Evaporating

It was bad enough when trading in the super-safe covered bond market was effectively halted a few weeks ago. Yes, covered bonds are technically mortgage related, but they are subject to very stringent rules as to the quality of collateral, plus investors can make claims on other assets on the issuers’ balance sheets. As the Financial Times described this development:

…when the industry’s governing council suspends market-making obligations between banks due to the rapidity of spread widening on such debt – as it did this week – observers are bound to fear the worst.

Jim Reid, credit strategist at Deutsche Bank, called the suspension of trading in the roughly €2,000bn market a “rather frightening spectacle” and said it was “cast-iron proof that we are in a credit crunch”

Now we have an even more troubling occurrence: a seizing up in the eurozone government bond market. As the Financial Times tells us:

A severe bout of illiquidity has hit eurozone government bonds, threatening to impair the ability of some governments and other borrowers to meet their funding needs in coming months, according to market specialists.

The development is striking because it underlines the degree to which problems in the US subprime mortgage market is spilling over into seemingly unrelated sectors, including traditionally safe government bond markets in the single currency region.

In recent weeks, risk premiums on eurozone government bonds, except those of Germany – which is the largest and most liquid market in the region – have been rising.

“European government bond markets are facing challenges they haven’t done for decades,” said Steven Major, head of fixed-income strategy at HSBC. “We are seeing a repricing of risk and a level of illiquidity we haven’t seen for a long time.”

Tensions in the secondary markets are also being fuelled by the “turn of the year” effect, which make banks increasingly reluctant to lend to each other in maturities extending beyond the end of any given year.

But analysts say the year-end effect should have dissipated by now if markets were behaving more normally…

The situation could become problematic for governments in the eurozone, as well as a swathe of other issuers from the region, including supra-national and quasi-government agencies, which have traditionally tended to issue a large proportion of their debt at the start of the calendar year – unlike in the US and the UK.

“There is a massive surge in funding in January and if things do not get back to a reasonable sense of normality by then, there could be some difficulties raising funds,” said Ciaran O’Hagan, strategist at Société Générale….

One European sovereign debt management official said: “It will be very difficult in the new year to conduct all the new issue activities, especially for corporates but for some sovereigns as well. There are so many standing in line and waiting.”

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