Divyang Shah, IFR Senior Strategist
It’s hard not to be positive on Ireland which in December is likely to be the first programme country to exit its bailout.
The decline on Irish 10-year yields this year highlights that the market is also pricing in a good exit from Ireland and a continued ability to fund itself in the market next year despite likely not having a EU backstop in place. With so much positive news priced in we feel it prudent to take a look at the risk scenarios during 2014.
Ireland will exit its bailout before the end of the year and is looking to do so without an EU backstop in place. This is not seen as an issue for the sovereign as markets remain optimistic that the €25bn in cash (held by the NTMA) along with the likelihood of further pre-funding for 2015 next year will prevent any problems.
Also, unlike other peripherals, the growth outlook for Ireland is a lot brighter with the IMF expecting GDP at 1.8% in 2014 compared to 0.8% for Portugal, 0.7% for Italy, 0.2% for Spain and 0.6% for Greece. The added advantage that Ireland will have is that not being in a troika programme will give it more fiscal flexibility to act should the need arise.
But what are the likely risks?
1) The first risk is that the market has priced in too much good news too quickly. 10-year yields on Ireland are below those of 10-year Italy and Spain highlighting the extent of market optimism relative to other peripherals. With this level of optimism already in the price, Irish debt is more prone to corrections on any disappointment with regards to fundamentals. Moody’s for one are still adopting a cautious line, ascribing a junk rating of Ba1.
2) Fed tapering might have been delayed but is still expected to commence next year and could see the market become more sensitive to peripheral risks in general. This is especially if the correction witnessed on safe havens such as Treasuries and bunds continues which could in turn see markets demand a higher yield from the non-haven countries. We saw a glimpse of this in May/June when peripheral yields moved sharply higher as the Fed introduced us to likely tapering plans.
3) A more significant concern is what happens in the event that the ECB AQR and EBA stress test sees a demand placed on Ireland to further prop up its banks. Failed stress tests would leave the sovereign relying on the €25bn cash stockpile it has built up with the bailout fund unlikely to provide assistance for legacy assets.
Using the pre-AQR/stress test window to build up the cash buffers and pre-fund for 2015 will be an important task for Ireland in maintaining market confidence that is priced into its sovereign bonds.
Further significant downside on yields seems limited for Ireland given the optimism that is already in the price and it is worth being cognisant of the risks at this stage.