The European Central Bank has dished out three years' worth of painkillers, but the euro zone still has a longer-term headache.
Tensions in the Spanish and Italian government-bond markets have clearly eased since the ECB provided €489 billion ($634 billion) of three-year loans to banks. Spain has been the biggest beneficiary, raising 20% of its full-year funding target already. But the majority of this issuance has been short-dated. Sales of longer-dated bonds could yet be challenging.
Short-dated bonds find a natural home with domestic banks that need to hold liquidity pools. Some may be doing the "Sarkozy trade," using cheap ECB funding to buy higher-yielding government bonds, as they were urged to do by French President Nicolas Sarkozy. The European Banking Authority's decision to rule out a repeat of last year's stress test, which forced banks to mark sovereign bonds to market prices, may fuel appetite for these potentially lucrative carry trades. A second long-term loan is coming in February.
But banks generally don't buy long-maturity bonds; they don't want the duration risk. Foreign buyers have also been reluctant to buy peripheral euro-zone bonds since last year. Spain and Italy will have to rely more heavily on domestic fund managers, pension funds and insurance companies to buy longer-dated paper. Spain has had some success, selling bonds due 2022 this week.
But yield curves reflect lower demand for longer-dated bonds. Since the worst point in November, two-year Italian and Spanish yields have plunged 3.8 and 2.9 percentage points to 3.93% and 3.25%, respectively. But 10-year yields have fallen only 1.1 and 1.5 points—to 6.27% for Italy and 5.23% for Spain.
Falling short-term yields will make a welcome dent in overall funding costs. But Spain and Italy shouldn't be tempted to boost short-dated bond issuance in turn. That would erode one of their main strengths as bond issuers: their long average debt maturities of 6.6 and 7.1 years, respectively. And it would only create a bigger refinancing risk once the medicine of the ECB's three-year loans wears off. A better strategy would be to pay up for long-term debt—even if yields look painful.
