My view is that the euro zone sovereign debt crisis will end in a combination of monetisation, breakup or default. Let’s review why.
Last summer, before the crisis hit Italy and Spain, I said that I expected Italy and Spain to come into the spotlight in a negative way:
My expectation is that Spain and Italy will be perceived as the new Ireland and Portugal, meaning they will now be stressed permanently – the spread to bunds will be permanently elevated at levels that are almost unsustainable for economic growth. The right way to deal with this is for the ECB (not the under-powered EFSF) to provide liquidity. Earlier, I suggested the ECB targeting the Italian-Bund spread at 200bps would be an effective way to go about this. But given the politics of the matter, that will never happen.
So far, this is how things have played out. The ECB came forward with the LTRO in late 2011 to tamp down a crisis that had engulfed Italy and pulled Spain in tow. But eventually crisis came back, with Spain in a starring role. The question is why?
Basically, this is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution. This includes France, Finland, Austria, the Netherlands and Germany.
Recently, Bill Gross made some perceptive comments on this score (underlining added for emphasis).
On Bloomberg, Gross said:
“I would be leery of German bunds simply because there are a few scenarios in which they can do well. If they will do well, if Germany leaves the zone and some way or another move back to the deutsche mark opposed to the euro and pay off obligations in euros and benefit because of it. Otherwise, increasingly, as we have seen over the weekend in terms of Greece, this kick the can environment adds liabilities to the German balance sheet day after day. They have what they call it a target 2 type of liability where they assume constant liabilities from Spain, Italy, and others as they move to the German Bundesbank. Increasingly, as the months move on, Germany becomes more and more liable for the euro balance sheet despite the possibility that Greece departs. Germany to me is a credit risk and certainly in terms of its tight shirt and shrinking shirt at the sleeves, is not an attractive market.”
Bottom line: Without the ECB to ensure lower rates in the euro zone and to make sure marginal sovereign euro area debtors on the verge of insolvency stay out of trouble, debtors in the euro zone will be picked off one by one.
The euro zone is a death trap for sovereign debtors as constructed. The ECB is the only entity that can change this.
Gross opines:
“I think the ECB as representative of euro land as a core has the ability. The question is do they have the will. Any central bank has the potential to increase their money supply to buy obligations and to write checks if they are willing to suffer the currency depreciation that comes from that. Up until this point, the euro has gone down in value. Will the ECB be willing to permit a 10-15-20% decline from this point forward? It’s not very German-alike in terms of their attitude. It’s not very Austrian in terms of their monetary policy, but increasingly the market expects them to at least move closer to the margin in that regard.”
By this point, after two years of crisis I would have thought, the ECB, Germans and their allies would have understood the flaws and worked to mitigate their effects. They have not. And so, contrary to what Gross says, we have to believe that they will continue to be unwilling to do what’s necessary to prevent debt deflation. This is bearish, not just for peripheral sovereign debt but for all euro zone sovereign debt. With Italy and Spain in trouble, I would look to the next three sovereign debtors for signs of the crisis widening. France, Belgium and Austria are where we should focus outside of Italy and Spain because they too will feel the pain of European inaction.
While German CDS have been moving up, the bond yields have remained low. And there are multiple explanations for why. What we need to watch is movement in CDS that is verified by the underlying bonds for France, Belgium or Austria.
Full Gross video below