Fears that Portugal will follow Greece prompt ECB to act

The growing prospect Portugal may follow Greece in needing more aid to skirt default may spur the European Central Bank to extend its response to the debt crisis, underpinning gains in the region?s stock market.

?Eurozone large-cap equities could rise 20 percent to 30 percent this year given the depressed starting point,? Michael Darda, chief economist at MKM Partners LLC in Stamford, Connecticut, wrote in a report to clients yesterday. Financial conditions have improved and ?there is no reason that this cannot continue so long as the ECB continues to keep its foot on the accelerator,? he said.

ECB President Mario Draghi is planning a second round of three-year bank loans next month, after lending 489 billion euros ($645 billion) in December and cutting the benchmark interest rate. The moves, while shoring up debt of Spain and Italy, failed to buoy Portugal, where the cost of insuring against default rose to a record yesterday. The yield on the 10- year bond climbed to a euro-era high of more than 18 percent today before declining to 16.40 percent at 4.44 p.m. in London.

The Euro Stoxx 50 Index, the benchmark for the 17-nation euro area, was down 19 percent last year before the ECB extended bank loans on Dec. 21. The index has climbed almost 7 percent since then.

?A resolution in Portugal would be positive, but the market has moved on to other things,? said Padhraic Garvey, a fixed-income strategist at ING Bank NV in Amsterdam. ?What we?ve had over the past few months is more differentiation.?

Investors have been selling Portuguese debt, perpetuating the increase in bond yields that is fuelling speculation the nation won?t be able to auction bonds next year before funds from its 78 billion-euro bailout run out.

Since the ECB stepped in with bank loans, the difference between Spanish and Portuguese 10-year bond yields widened by 362 basis points and the gap with Italy grew by 410. Italian and Spanish bonds gained as the ECB lending helped the two countries sell more than 40 billion euros of debt since the start of the year at lower costs then in recent months.

The renewed interest in euro-region debt hasn?t trickled down to the most peripheral of countries in the European Union, with Greece struggling to conclude a deal for bondholders to accept writedowns and Portugal trying to convince investors they won?t be next in line for a similar haircut.

Greek bondholders are being pushed to cede more ground after agreeing in October to take a 50 percent reduction in the face value of more than 200 billion euros of Greek debt. Portugal may face a funding gap of 9 billion euros next year unless it can sell longer-maturity debt, which is made more difficult with 10-year borrowing costs as high as they are.

Portugal Prime Minister Pedro Passos Coelho reiterated yesterday that there was no risk of investors being asked by government officials to take losses on Portuguese debt. ?What matters the most at this time is that all the financial stress is removed,? he said while at the EU summit in Brussels.

The ECB will remain active in ?supporting government bond markets of the countries that have come under pressure,? said Bill Dinning, the Edinburgh-based strategy chief at Kames Capital Plc, which manages about $75 billion. ?I don?t think we should doubt the motivation, which is to continue with the euro zone in its current construction.?

The stalled Greek debt talks and the surge in Portuguese yields overshadowed yesterday?s EU summit where leaders agreed to speed sanctions on high-deficit states and require euro countries to anchor balanced-budget rules in national law.

Portugal and Greece, which account for 4 percent of the euro-region?s $12 trillion economy and 16 percent of its debt, are ?a distraction,? Darda wrote. Spain and Italy, which account for 80 percent of euro-area borrowing, are ?far more important,? and ?with the ECB moving to expand its balance sheet and lower rates, there is a better chance for Spain and Italy to make it despite what happens to Greece and Portugal,? he wrote.

Italy sold 7.5 billion euros of bonds yesterday, paying 5.39 percent to lend for five years, the least in four months. The issuance will help fund 25.8 billion euros of bonds maturing tomorrow, the country?s biggest redemption of the year.

Spain auctioned 2.5 billion euros of bills on Jan. 24, pricing three-month notes at 1.285 percent, the lowest since March. The country sold about 17 billion euros in bonds in January, about 20 percent of its total target for all of 2012.

?Despite increasing market concerns about Portugal, there is enough support for Italy and Spain and interest from domestic investors in terms of demand for bonds, as generally seen over the past month,? said Orlando Green, a fixed-income strategist at Credit Agricole SA in London.