Yields Fall At Spanish and Italian Bond Auctions; Is 'Sarko Trade' Working?

The ECB’s plan of encouraging the “Sarko Trade” appears to be working. In an effort to boost liquidity and reduce rates in the sovereign debt market, the central bank offered European banks unlimited amounts of three year loans last month via something called an LTRO facility. While there has been a great deal of consternation about whether the plan would do anything other than boost bank liquidity, falling yields at today’s Spanish and Italian bond auctions would seem argue that the plan is working as appetite for bonds appears to be improving.

At Thursday’s all-important Spanish bond auction, demand was high and borrowing costs fell. On the demand side, Reuters noted that the Spanish Treasury raised €10 billion from the auction of three different bond offerings on Thursday, which was double the original target.

On the yield side of the equation, rates fell by more than 1% across the board at the auction. Spain sold €4.3billion of new three-year bonds at 3.384%. The auction produced a bid-to-cover ratio of 1.8. The Spanish treasury also sold €2.5 billion of bonds maturing 30-Apr-16 at an average yield of 3.748%, which was down more than a full point from the 4.871% rate seen at the last auction in July. In addition, it sold €3.2B of bonds maturing 31-Oct-16 at 3.912%, down from 4.848% in early November.

The real eye-opener was the extent to which Italy's borrowing costs fell at their auction. Reuters reports that Italy paid less than one-half the rates it was forced to pay just a month ago in order to sell one-year bills at its first auction of 2012. The yield on the one-year bills fell to 2.735% from the nearly 6% that the country was forced to pay in mid-December. The rate was the lowest since June 2011. Italy will be back in the market on Friday to sell up to €4.75B in debt, including its three-year benchmark bonds.

Reuters reports that European banks appeared to lend support to the bond auction thanks to special LTRO funding provided by the European Central Bank, which offered banks nearly half a trillion euros of three-year loans in December and will make a similar offer in February.

Recall that banks have effectively borrowed at 1% for three years and can now buy government bonds from countries like Italy and Spain, which provides a massive profit spread.

European banks are likely under political pressure to implement such a plan as it was French President Nicolas Sarkozy that originated the strategy. Since then, the idea of borrowing from the ECB at 1% and reinvesting in European sovereign debt at considerably higher rates has been deemed the "Sarko Trade."

Stock markets in Europe have responded favorably to the news of the falling yield and U.S. futures are trading higher.

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