Fixed Income

Goldman calls time on Europe peripheral debt rally


A two-year rally in the debt of struggling euro zone countries may have defied all sense and logic given the weak fundamentals of these so-called peripheral nations. Now the popular trade may have come to an end.

Goldman Sachs, in a flurry of action from its rate strategists on Tuesday afternoon, announced that the "peripheral" theme had finished and it was turning neutral on its sovereign debt. It now predicts that the interest rates from bonds of countries like Italy, Portugal and Spain will move higher along with Europe's core as euro zone inflation begins to "bottom-out" and U.S. yields pick up.

"Given our strategic view on core bonds, we expect EMU ((European Economic and Monetary Union) peripheral yields to increase in coming months and the curves to steepen alongside the Bund curve," the team, led by Chief Interest-Rate Strategist Francesco Garzarelli, said in Tuesday's research note.

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This rally can be traced back to the "whatever it takes" speech by Mario Draghi, the president of the European Central Bank, in July 2012. Draghi effectively backstopped the region and diminished fears of a euro zone breakup. His dovish words since and a series policy moves - some real and some just implied - have helped peripheral debt to cool down from the red hot levels seen at the height of the sovereign debt crisis of 2011 and 2012.

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Goldman Sachs warned on the implications of higher yields for the growth and debt sustainability for some of these countries and urged investors to begin discriminating between the different nations.

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"We are more concerned about Italy where, over the past few months, economic activity data has continued to surprise on the downside and institutional and structural reforms have not yet been delivered," Garzarelli said. He added that Portugal was another uncertainty because bailout funds were being erased after the state help for Banco Espirito Santo and the saga might leave some legacy in terms of "institutional transparency and credibility."

Nicholas Spiro, the managing director at Spiro Sovereign Strategy, warned of false dawns on calling the end of the peripheral debt rally but said that there was indeed a "whiff" of a rise in yields in the air.

"The rally has been conspicuously indiscriminate," he told CNBC via email. "Bond prices have become far too detached from underlying fundamentals. It has been a case of convergence in the bond markets amid divergence in the real economies - particularly in the case of Italy, and even France to a lesser degree."

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Yields on 10-year government debt from these peripheral nations rose on Tuesday as the price declined - yields have an inverse correlation to their price. Weak manufacturing and services data added to the selloff and investors remain concerned about a fragile recovery in the region. Spanish 10-year debt yields still remain at 2.562 percent, surprisingly close to U.S. yields, and have tightened from levels of over 7 percent in July 2012.