What Portugal Portends

Story Highlights:

• Wednesday, Portugal completed a bond auction for €1 billion of debt at 5.99%, well above yields from only six months ago.
• Short-term solutions to Europe’s debt woes, like the European Financial Stability Facility, are set to expire in 2013, and permanent plans lack many critical details.
• European bank stress test details were leaked early this week as well but did little to reassure investors.
• Politicians would do well to foster more transparent discussions on proposed measures.

On Wednesday, Portugal’s much-watched €1 billion bond auction for debt maturing September 2013 saw good demand. The bid-to-cover was 1.6x, but the resulting yields rose to 5.99%—much higher than the 4.7% yield on the last auction for similar duration debt six months ago. The elephant in the room, of course, is the European Financial Stability Facility (EFSF), set to expire June 2013. The gap in Portuguese yields on debt maturing before and after the EFSF’s expiration highlights two points: One, the much lower-yielding debt maturing pre-EFSF expiration shows investor confidence in a finalized plan. However, sharply higher yields on debt maturing after EFSF shows a perception of heightened risk—likely stirred by the lack of permanent resolutions to the European Economic and Monetary Union’s (EMU) stresses.

Some uncertainty on the euro’s future may be clarified in coming weeks. European leaders are set to meet in Brussels today and again on March 25^thto discuss, among other things, Germany’s pact for competitiveness and a permanent bailout fund—the European Stability Mechanism. But note: Clarity and transparency will be important. Recent meetings on the subject have produced little more than broad brushstrokes of a master plan and vague language (like the goal of “harmonizing” corporate tax rates) devoid of any real information or details.

The lack of transparency from European officials doesn’t end there. Earlier this week, Germany’s Handelsblatt leaked details of the second EU bank stress test parameters. Some analysts believe the European Banking Authority (EBA) intentionally leaked the news to make test criteria more public and reduce potential surprises. While reducing surprise is a good aim, the means just led to further questions—why not just announce the criteria formally? Whether intentional or not, the leak did little to calm markets. As we’ve mentioned previously, stress tests done badly can be a lose-lose situation. If the tests are too strict, results might show a huge chasm requiring capital-raising measures. (One can argue well-executed stress tests make capital raising easier, but it’s a delicate balance.) If the tests are too easy, regulators risk missing material weaknesses, (e.g., a handful of Irish banks failed after passing last year’s stress tests), which provides more fodder for skeptics and doubters. Additionally, uncertainty about the outcome prior to the release of results can add to near-term volatility.

Progress in March’s meetings could be a step in the right direction, but since many key issues are post-2013 and likely require significant concessions from many EMU nations, it doesn’t appear likely there’s a quick fix. Along the way, don’t be surprised by market volatility tied to European matters—but it’s important to recognize the worst-case scenario (a disorderly, rapid breakup of the euro) is far from likely in 2011. Still, many long-term issues must be resolved and European politicians would do well to foster more transparency—leaking news doesn’t count—on proposed measures to support weaker countries and create a better EMU framework going forward. If that is indeed what they really want.