Irish bond spreads

I was idly looking for patterns in the daily evolution of eurozone government bond spreads (like you do) and thought I would share some findings. The spread of Irish Government bonds over the 10-year German benchmark have of course trended upward during the period since early September 2008 to last week:

If we compute principal components of the spreads of ten euro-currencies we can try to isolate the different factors: separating factors that affect all countries from those that affect Ireland in relative isolation.

Using daily changes in the spreads, the first three principal components explain 80% of the total variation in the ten series.

All ten bonds have roughly equal loadings on the first PC (which alone explains 62%). We can therefore think of PC1 as measuring fluctuations in general aversion to credit risk.

PC2 seems to measure a component which is irrelevant to Ireland — from the loadings this one looks like Club Med vs the North.

But PC3 is an almost Ireland-specific factor, much smaller loadings on the other countries. The big action in PC3 is on just three almost consecutive days in January: the 16th (Anglo nationalization), 19th and 21st.

To me this illustrates just how easily spooked this particular market is. Anglo nationalization was not even demonstrably bad news. When will it settle down to a realistic assessment of Irish risks?


The linear regression equation explaining changes in the Irish spread in terms of three principal components is (t-stats in parentheses):

ΔIreland = 0.020 + 0.015 PC1 + 0.042 PC3 + 0.024 PC4
(17.7) (32.7) (32.0) (15.6)
RSQ=0.958 DW=2.16

The constant term reflects the general upward trend in Ireland’s spread (which is not explainable by this method).

(Of course there are many methodological tricks one could explore, but it’s getting late and this seems enough for the present. Probably some readers do this stuff for a living!)

4 replies on “Irish bond spreads”

Full text of Lombard Street Research mentioned above:

Ireland can easily see off the euro-bullies

WE SUGGEST: Large government bond spread is a buying opportunity
SUMMARY: Ireland can absorb any losses in its financial system, and a major recession, and remain enviably richer than Britain, Germany and France, with good long-term growth prospects. In the worst economic and financial scenario its net government debt will be far lower. Commentariat hysteria is a buying opportunity.

A lot of attention has been paid to Irish financial and economic problems recently. The north-central Europe free-riders on other countries’ domestic demand are smug about the temporary difficulties of the more dynamic spender economies. (The crash in German and Benelux GDPs following that of their exports may soon make them wring their hands, though, dependent as they are for exports, and therefore output and income, upon deficitcountry borrowing.) Much the same people are determined to punish Ireland for rejecting the latest version of the European Constitution in a referendum. Their hope is that financial stress will force Ireland to seek help from fellow EMU members – read “Germany, France and Benelux” – for which the condition will be another referendum pronto, the assumption being that an Irish populace cowed by strong recession will cave in and approve it.

In reality, Ireland has “nothing to fear except fear itself”. Its income far exceeds European norms, as our chart shows. It is a small, service-based economy with a substantial migrant element in the labour force, mostly from CEE members of the EU. Prime Minister Cowen recently said real GDP would fall 10% over three years. My colleagues praised him for not covering up, unlike most politicians. But perhaps he did. Maybe, Irish real GDP will fall 15-20%. If so, many of the migrant workers will go home, per capita income will fall by less, and remain enviably ahead of Britain, Germany and France. Much the same happened in 1975 in Switzerland, when real GDP plunged and unemployment rose from under 100 to about 30,000, a minimal 1% of its labour force. In a small flexible service economy, with a small public sector, incomes can much more readily be lowered than in large, bureaucratic economies like most European countries. And the basic Irish long-term growth potential remains intact: ready access to relatively unlimited labour, capital and land.

And the financial problem? Ireland has virtually no net government debt. Its broad money supply is about 130% of GDP. Suppose the financial sector needs to be recapitalised at 20% of this balance sheet (an extreme assumption). Then Irish gross debt might rise by 26% of GDP, reaching the British level and remaining somewhat lower than Germany and
France. Its net debt would rise by less, depending on the actual losses emerging, and would remain well below most other countries’, including all the major Europeans. Meanwhile, the widening of government bond spreads against German bunds must be seen against the falling absolute level of the latter. Current Irish 10-year yields are an affordable 5½%.
Ireland certainly stored up trouble for itself by adopting the euro and making itself vulnerable to the drop in sterling that has actually happened. The case for currency linkage to a major neighbour is understandable for a small economy, but the logical link is to Ireland’s largest trading partner, the UK, or its second largest, the US. But other countries should envy Ireland its problems, and the EMU panjandrums should switch their attention to the economic disaster that is developing amongst the Mediterranean members of EMU.

Charles Dumas


in addition to giving the coefficients, can you multiply those by the RHS variables to tell us how much of the rising spread is due to which factor?

As to the question of when the market will settle down to a realistic assessment of Irish risk: presumably this will largely depend on when markets feel that they have been given the full truth about the banks? Which leads back to the point that everyone seems to agree on, namely that the sooner we get the bad news out of the way about how big the holes are in these institutions, the better.

Kevin: Since the principal components are zero mean by construction, essentially all of the trend is in the constant term. It’s the short-term surges that the principal components capture. Thus PC3 added just over 50 basis points in four days from Jan 16.

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