The euro crisis is not over, Portuguese edition

Remember how French President Hollande was saying a month ago that the euro crisis is over? Well, he was wrong. Today Portugal’s yields on 10-year paper vaulted to as high as 7.9% before settling back down again. Just two months ago, yields were at 5.23% and Portugal was going to market with a 10-year bond offering.

The Socialist opposition leader is saying that the country needs to abandon austerity as unemployment, business bankruptcies and non-performing loans skyrocket. Meanwhile the government is following the dictates of the Troika by pursuing an aggressive and front-loaded austerity campaign with the hopes of qualifying Portugal for an OMT-style exit from the current bailout program. It’s not working.

I never believed this approach would work but events on the ground had been proving me wrong for many months earlier this year. The reality is that Portugal did regain market access and was really putting on a show as recently as two months ago. I penned a piece on why I may be wrong on Portugal in May as a result of that.

First, here’s what I said in February, predicting problems:

Portuguese unemployment has hit a post-euro high of 16.9% on the back of an accelerating contraction in the economy. Youth unemployment is now 40%. The austerity in Portugal is accelerating the decline in economic output. In Q4 the quarterly contraction hit 1.8%, up substantially from Q3′s 0.9%. Yet, the latest information is that even the IMF, which elsewhere has talked about back loading its austerity regime, is still committed to front-loaded austerity in Portugal. They have told the Portuguese that the most draconian budget in Portuguese democratic history won’t be enough. They want more cuts in 2013. Ostensibly, the reasoning here is that with Ireland on the verge of OMT status, Portugal needs to get there too and they cannot do so based on the present numbers. So, despite the hardship that front-loading austerity represents, the IMF is doubling down on this strategy in the hopes it will allow Portugal to exit the Troika programs into an OMT-style bailout. I believe this strategy will fail and Portugal will not make its targets as the economy and tax receipts decline.”

Sounds good, right? Well, by May, it looked this way:

“The gist of my argument [from February] is that the poor economic fundamentals would eventually drag down sovereign bonds and mean that Portugal would be barred from an OMT-style bailout. As it turns out, the opposite has happened. It is still early days as Portugal is a long way from applying for an OMT program. So I could still be proved right in the end. Still, it bears noting how things have progressed since February. And what I am seeing is a widening dichotomy between bond performance and economic performance rather than a narrowing one that drags sovereign bonds down.


“I think the big takeaway here then is that Cyprus worked in the sense that it has indeed brought sovereign – bank decoupling to the European bond markets. What the Italian chart most clearly shows of all the charts above is that post-Cyprus, sovereign bond risk has diminished because the sovereigns are no longer seen as at risk for the contingent liabilities of their banking sectors.”

Unfortunately for Portugal, things are now moving in the opposite direction with the bonds moving toward the fundamentals as one should expect. What happened? I would call it risk-off.  On June 21st the headline was Greece, Portugal suffer most in eurozone from FOMC fallout and since that time yields in those countries have spiked as bond investors have exited the leveraged, riskier plays they made in the wake of the Fed’s tapering comments. So the fallout from the Fed’s tapering has been a move to risk-off that has caught Portugal out and caused sovereign risk to re-emerge in the eurozone.

Now, let’s remember why this is so. In order to make it into the OMT program, first, Portugal has an unemployment rate of nearly 18%. Second, the country is committing to an extreme front-loaded austerity program like Greece’s despite the Supreme Court’s ruling that their original implementation of this plan was unconstitutional. They have rejiggered the austerity plan and are now doubling down on austerity with this new plan. Third, the government has plundered its pension funds in order to get it over the hump as the austerity is not going to be nearly enough to meet its nearly 30 billion euro funding gap over the next two years. Fourth, in the wake of the public sector retrenchment which began in 2011, bad debts have been rising with two of the largest banks reporting that as much as 10% of loans were at risk for default. Lastly, political instability has reared its head as the Portuguese finance minister has resigned.

Conclusion: Despite record unemployment, Portuguese wages are still too high to get a boost from exports. And now debt deflation has kicked in with Portuguese banks needing a capital infusion. There is zero chance now that Portugal can move to Ireland’s position with near-full market access. A fall into the Greek position of default, restructuring and serious depression is just as likely if not more so.

So, the euro crisis is not over by a long shot. Moreover, the destructive policy choice in Portugal has made the situation there considerably worse and has created this problem. As I have been saying, the fundamentals are poor. It was a gift that bonds did not re-couple to these poor fundamentals earlier. Now that they have, I doubt the EU will relent. And that means problems for Portugal and the euro zone in my view. If these problems spiral out of control, we could enter another full blown crisis before the year is out.

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