Why the European sovereign debt crisis is back on

About a year ago, I wrote a post which I titled “Why the euro crisis will happen again and Italy will be involved“. And the gist of that piece was that Europe had wasted the sovereign debt crisis. Nothing had fundamentally changed in Europe. Greece was not a special case. The problem wasn’t Greece. The problem was the euro’s design. And that meant crisis was sure to return.

The reason I highlighted Italy is because it was the clear weak link economically and politically. And it had a weak banking system. Unfortunately, the weaknesses I highlighted a year ago have proved insurmountable. The European sovereign debt crisis is back. And I think it will run for some time.

So here’s how I want to play this. I’m not going to write an all-encompassing post on what’s wrong, what the reaction will be by policy makers and how it’s going to affect your portfolio or your economy. Instead, I am going to chunk this as the news flow comes out. And I want you to follow my commentary as one piece building on the prior ones.

In this piece, I am just going to set the stage with some key things to watch and why they have occurred.

First, Italian spreads are gapping out, widening versus German Bunds, but also versus Spanish and French government paper and closing the gap with Greece. The reason is both default risk and redenomination risk.

What’s happened is that the President of Italy has thwarting the formation of a eurosceptic government, installing a former Italian IMF official deficit hawk as interim Prime Minister. The interim Prime Minister’s views are directly counter to the eurosceptic parties’ views. And so that sets up a bitter election battle for later in the year, with the likelihood that this election will be seen as a referendum on the euro.

As a member of the euro area, Italy has no monetary sovereignty. The only thing keeping its debt yields low is the implicit backstop of the ECB. But because of the political turmoil, this backstop is now in question. And Italy could default on its debt as a result.

I don’t think that’s going to happen because it would be calamitous. But, at a minimum, Italian yields will surge until the ECB is forced to step in because there are no signs of a political solution in the near-term.

Second, Spanish spreads are gapping out too. And this is a sign of contagion that will eventually draw a response from the ECB as well. The Spanish 10-year spread to German Bunds has gone from about 70 basis points a month ago to about 100 basis points. At the same time, the French spread has barely budged despite France doing much worse economically than Spain.

I look at the Spanish-French spread as a proxy for crisis, for contagion, because that should not be happening. In a non-crisis world, Spain would benefit from its economic performance. In a crisis world, it partially recouples to Italy due to the increase in redenomination risk. The ECB will not want to see this. And will react eventually.

Third, the euro has become to come under pressure as money flees to safe havens like the US dollar. For the US, this is bitter because it creates upward pressure on longer-dated US government bonds, lowering their yield.

The US yield curve has flattened to within a whisker of 40 basis points between the 2-year and the 10-year US Treasury. And this is occurring before the Fed meets to initiate its second rate hike of the year. Depending on what the Fed’s guidance is, we could even see the curve flatten to 25 basis points between the 2-year and the 10-year. And while I have predicted this, it is not a good sign.

A yield curve as flat as that is one move from inverting. And that inversion, if it occurred, should be taken as a signal of coming credit turmoil and economic weakness.

I am going to leave it there for now. There is much more to come though. This crisis is likely to have legs.