Doubts Are Slowly Creeping In

Hitherto, the eurocrats have always kept up the party line in public, namely insisting that the debt problems can be solved by means of intervention. We mentioned many weeks ago that EU financial commissioner Olli Rehn would come to regret his sotto voce pronouncement that the 'crisis had been successfully contained to the 'GIP trio'. At the time, CDS spreads and yields of Portugal, Ireland and Greece had for some time diverged sharply from those of Spain and Italy. It appeared as though the markets had determined that the 'big fish' were out of danger. We have always held that correlation would make a comeback and so it has.

However, it appears now that 'crisis management fatigue' is setting in. The bureaucrats and politicians want to go on vacation. Some in fact are on vacation, such as German chancellor Angela Merkel – and it appears she has no intention of returning to deal with Italy and Spain at this time. Moreover, it is now readily admitted that there is 'nothing we can do.' That is certainly a new one.

Meanwhile, Italy's prime minister Berlusconi still thinks he must primarily go after the so-called (by him) 'locusts' – i.e., speculators and panicked bondholders that are selling selling Italian bonds and buying credit default swaps on Italy's debt. He still has his priorities in proper order it appears – although he did acknowledge in the same breath that the eurocracy will need to produce something the markets actually like, namely, 'certainty'.

As Reuters reports:


„The European Union acknowledged on Wednesday that investors now doubt whether the euro zone can overcome its debt crisis and Italy's Silvio Berlusconi called for more action to ward off market attacks.

European Commission President Jose Manuel Barroso said a surge in Italian and Spanish bond yields to 14-year highs was cause for deep concern although they did not reflect the true state of the third and fourth largest economies in the currency area. "In fact, the tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis," Barroso said in a statement.

He urged member states to speed up parliamentary approval of crisis-fighting measures agreed at a July 21 summit meant to stop contagion from Greece, Ireland and Portugal, which have received EU/IMF bailouts, to larger European economies.

But neither he nor European Monetary Affairs Commissioner Olli Rehn offered any immediate steps to stem the crisis, which has flared again with full force less than two weeks after that emergency meeting.

Italy has borne the brunt of a selloff triggered by the unresolved debt crisis and fears of a global economic slowdown.

"Our country has a solid political system … we have solid economic fundamentals. Our banks are liquid, solvent and they've easily passed the European stress tests," Prime Minister Berlusconi, who has been largely silent, closeted with his lawyers over several ongoing trials, told parliament.

"The markets didn't reflect, and still don't reflect the importance of (European) interventions that have been taken. So it's essential to give certainty to markets," he said.

Italian Economy Minister Giulio Tremonti held two hours of emergency talks with the chairman of euro zone finance ministers, Jean-Claude Juncker, in Luxembourg but neither disclosed anything of substance after the meeting. Tremonti also conversed with Rehn.

A European Commission spokeswoman said there had been no discussion of a bailout for Italy, which would overwhelm the bloc's existing rescue funds. The market turmoil caused alarm in some parts of Europe but apparent insouciance in the bloc's biggest economy, Germany.

"Italian and Spanish bond yields rose to their new record highs. This is a very alarming and scary thing," Finnish Prime Minister Jyrki Katainen told public broadcaster YLE. "The whole of Europe is in a very dangerous situation."

With many policymakers on holiday, there seemed little prospect of early European policy action, although euro zone governments were in telephone contact about the situation.

German Economics Minister Philipp Roesler said Italy and Spain were not even discussed at Berlin's weekly cabinet meeting which he chaired in place of Chancellor Angela Merkel, who is on vacation and did not call in.

A German government spokesman said Berlin saw no reason for alarm over the selloff of Italian stocks and bonds and was focused on implementing the latest euro zone summit decisions. In stark contrast, Spanish Prime Minister Jose Luis Rodriguez Zapatero delayed his holiday and held crisis talks with ministers ahead of a crucial bond auction on Thursday.

The euro zone's rescue fund cannot use new powers granted at last month's summit to buy bonds in the secondary market or give states precautionary credit lines until they are approved by national parliaments in late September at the earliest.

The European Central Bank could reactivate its bond-buying program, which temporarily steadied markets last year but has been dormant for more than four months. Weekly data released on Monday show it has so far refrained from doing so despite market rumors to the contrary last week.


(emphasis added)


So the upshot seems to be: there is actually no need to discuss Italy, since there's anyway nothing we can do about it. Let's rather go on vacation. We actually have some sympathy for that idea, because there is indeed nothing that can be done about it. As for the idea that 'ECB buying of peripheral bonds temporarily stabilized markets', it did no such thing. It was a complete failure from the very beginning. Not surprisingly, the ECB is reluctant to repeat the exercise.

Tremonti and Zapatero are understandably worried, but we fear that conversing with Jean-Claude Juncker and Olli Rehn isn't going to change anything either.

In the meantime, bank stocks in the euro area keep getting hammered over their exposure to sovereign debt. As we noted on occasion of the EBA's 'stress test', as flawed an exercise as it was, it did reveal a great many details about the positions of the tested banks – and in many cases those details were not exactly comforting. In this context we would like to point readers to a recent article on the EFSF by Peter Tchir, where he discusses that particular construct as it now stands after the latest euro-group summit. Of course the national parliaments have not even approved this 'new and improved' EFSF yet, but assuming such approval is obtained, the vehicle and the operations it has been designed for are evidently deeply flawed. As Peter rightly notes, all that talk about 'handing the EFSF € 2 trillion' or whatever fantasy figure people pull out of their hats is illusionary. Moreover, it seems that the EFSF's new operations could easily accelerate the confidence crisis that is currently engulfing the banks, as it could force them to recognize some of the losses they would actually have to admit to if they marked their banking books of sovereign debt to market – precisely one the main things the bailouts are designed to avoid.

The fact that the eurocracy's party line is now slowly but surely crumbling is  quite noteworthy to our mind. Perhaps it will be the first step in rethinking the failed policy of bailouts and interventionism.


Euro Area Charts & The VIX

Here is an update of our 'usual suspects' as of yesterday's close. CDS prices, euro basis swaps and yields in basis points, color coded where applicable. As can be seen, the crisis just won't let up (there have been tiny pullbacks in yields in today's trading).  As it were, the eurocracy really has no plan for Spain and Italy, because it cannot have a plan. These are too big to bail if push comes to shove, so all that is left is to hope for the markets to calm down of their own accord, which will turn out to be a forlorn hope as long as the fundamental problems remain unaddressed. As we keep saying, piling more debt atop existing debt is not a solution.

5 year CDS on Portugal, Italy, Greece and Spain – new all time highs for CDS on Italy and Spain – click for higher resolution.



5 year CDS on Ireland, France, Belgium and Japan – new all time high for CDS on France's debt. France of course is 'the' core nation besides Germany. Belgium approaching the 'danger zone' as well now – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – all still going higher – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – new high for Slovakia, although these are still at relatively low absolute levels (there is no problem with Slovenia's and Slovakia's public indebtedness – they simply remain 'guilty by association', as they must contribute to the EFSF's guarantees as well) – click for higher resolution.



5 year CDS on Romania, Poland, Slovakia and Estonia (Estonia is also a victim of euro area association here. Its public debt to GDP ratio is only 6%) – click for higher resolution.



5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – Turkey retains its correlation with the euro-land members – click for higher resolution.


The Markit SovX index of CDS on 19 Western European sovereigns – this remains a bullish chart as we always point out and it is once again closing in on its July highs – click for higher resolution.



One year euro basis swap – at minus 38 basis points it is at yet another new low for the move. This swap should normally oscillate around the zero line – that it does not indicates problems with dollar funding in the euro area's banking system and a perception of growing counterparty risk – click for higher resolution.


Five year euro basis swap – going in the wrong direction as well – click for higher resolution.



10 year government bond yields of Italy and Austria, UK gilts and the Greek 2 year note. Italy's yields at a new high, yields on gilts at a new low. The latter demonstrates that the markets have a sense of humor. The same can be said of the decline in Austrian government bond yields – note that the CDS on this debt are exploding concurrently. Something doesn't quite compute there – click for higher resolution.



The VIX – after a close outside of the Bollinger band, it has closed back inside it. Usually that indicates some sort of near term low is close in the stock market. See also the next chart – click for higher resolution.



Stock prices and the VIX have put in a divergence (lower low in stocks vs. lower high in VIX). Often this presages a short term bounce – click for higher resolution.


Charts by: Bloomberg



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2 Responses to “Euro Area – The Party Line Crumbles”

  • amun1:

    German 10 yr yields 2.3%. Italian 10 yr yields 6.2%. Spanish 10 yr yields 6.28%. Meanwhile, the Euro’s trading at $1.41.

    Something’s wrong with this picture. Those spreads are inconsistent with survival of the Euro. Either German yields have to rise, Italy and Spain have to fall (or both), or the Euro is headed for a mighty crash.

    • I expect the euro to eventually weaken considerably – either because the ‘solution’ that will ultimately be implemented is money printing by the ECB, or the euro area crumbles.
      Printing would be the ‘easiest’ way out, so they are probably going to do it eventually (in fact, it may have already begun). Still, as I mentioned previously, Germany might actually object rather strongly to that.

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