Thursday’s bailout announcement in Europe represented significant progress in that debt reduction is what has to take place. However, the odds of Europe being off the market’s radar going forward are almost zero. The question is how long will it take to become a problem again - three days, three months, six months? We believe the stock market rallied more based on the relief European leaders demonstrated they can make difficult decisions, rather than based on the feeling everything is fine in Europe. Reuters hit on some key points:
Euro zone leaders are as far as ever from finding a lasting solution to the bloc’s underlying problem of economic divergence, despite their latest progress in managing the symptoms of its debt crisis.
“This is another step in the right direction, but it is not enough to get us to the end game,” said Stephane Deo, chief European economist at UBS. “It buys time but it does not address the fundamental problem of the sovereign debt crisis.”
Nearly 35 percent of Greek bonds are in the hands of public institutions such as the European Central Bank (ECB) and is not subject to the mooted writedown. As a result, Greece’s debt would still be an eye-watering 120 percent of gross domestic product in 2020 — exactly the level of late 2009. And even that assumes decent economic growth and ambitious structural reforms including large-scale privatization of state assets.
“From the macroeconomic point of view, if it’s purely a 50 percent ‘haircut’ on the nominal bonds, without an extension of the maturity and a reduction of the coupon, I’d still be reasonably suspicious about the sustainability of Greek debt,” Deo said.
The European Central Bank (ECB) is similar to our Fed. They have reluctantly been purchasing Italian and Spanish bonds hoping to buy leaders time to stabilize the markets. When the ECB is buying bonds something is wrong. The “euro-saving” deal was announced on Thursday and stocks zoomed higher. The bond market is what matters here since access to credit is the key issue. How did bond buyers react? Not well.
In a new bond offering on Friday, where bids are taken to determine the rate of interest the market demands, Italy’s borrowing costs hit new euro-era highs. Think about that - (1) the worst on record bond auction took place AFTER the bailout deal was announced , and (2) the ECB is still buying Italian bonds, which means the interest rate set by the “market” is artificially reduced via the central bank’s purchasing power. What would Italy’s interest burden have been in a real market auction (no ECB)? Until Italy can finance its government at reasonable rates and with no central bank involvement, we still have a major problem. Early Saturday morning, Reuters reported:
European Central Bank President Jean-Claude Trichet said in an interview in a German newspaper to be published on Sunday that the euro zone sovereign debt crisis was not yet over and that it was too early for the all-clear signal. He said the ECB will carefully track the progress of governments’ reform measures and said the time had now come to “see some action.” “The crisis isn’t over,” Trichet told the German newspaper, according to an advance text released early on Saturday. He said the precondition for that was “that the rules of the Stability and Growth Pact are more thoroughly and more aggressively implemented.” “The quick and complete implementation of the decisions is now absolutely decisive,” Trichet said.
The market’s attention will now shift toward Italy, a country “too big to fail and too big to bail”. More from Reuters via the Calgary Herald:
Italy’s borrowing costs jumped to record levels on Friday, underlining its vulnerability at the heart of the eurozone debt crisis and skepticism about whether the struggling government of Prime Minister Silvio Berlusconi can deliver vital reforms. The 6.06 per cent yield paid at an auction of 10-year bonds was the highest since the launch of the euro and not far from the level reached just before the European Central Bank intervened in August to cap Rome’s borrowing costs by buying Italian paper. Italy, the eurozone’s third largest economy, is once more at the centre of the debt crisis, with fears growing that its borrowing costs could rise to levels that overwhelm the capacity of the bloc to provide support amid chronic political instability in Rome. Berlusconi in a speech in Rome said the record yield would weigh on the country’s finances, but insisted Italy would meet its target of balancing the budget by 2013.
In Saturday’s edition, the Wall Street Journal summed up the situation this way:
Initial relief over Europe’s latest attempt to end its debt crisis faded on Friday as investors fretted about the plan’s lack of detail and grew more skeptical about Italy’s turnaround effort. The wan response from bond markets underscores how challenging it will be for European leaders to convince financial markets that Thursday’s broad agreement is sweeping enough to enable troubled countries such as Italy and Spain to work their way out from mountains of debt.
“Italy remains a big problem,” said Alessio de Longis, a portfolio manager at OppenheimerFunds. Italy has been failing to deliver on promises, he said. Instead “it’s only talk—chiacchiere in Italian,” he said.
The firepower of this fund…is not enough to calm fears,” said Silvio Peruzzo, an economist at RBS Global Banking & Markets in London.