Sunday, July 17, 2011

The Beginning of the End of Europe

The Beginning of the End of Europe

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Yesterday, the European contagion spread to Italy and Spain. The sovereign debt of those two countries swooned—for no discernible reason.

No discernible reason whatsoever: The Italian and Spanish bond markets just sort of . . . plopped, like when a learning-to-walk toddler suddenly plops on his behind? Exactly like that: For no reason whatsoever.

Please select the straw you think
broke the back of the eurobond markets.
The only conclusion that I can draw from this Monday swoon is that we’ve hit the tipping point: This is the start of the eurozone endgame. It is now only a matter of time before the eurozone breaks apart. Therefore, get back in your seats, buckle up, and brace yourselves good—‘cause it’s gonna be a bumpy ride.

Let me explain my thinking:

For those of you who somehow have missed out on this movie: Europe has been in trouble because the nations of the periphery—Portugal, Ireland, Italy, Greece and Spain, the so-called PIIGS—have massive sovereign debts which they simply cannot pay.

Regardless of how the debt of the PIIGS got to be the size that it is, none of them can survive without cash: Cash to maintain their government services, and cash to pay off their debts.

In the case of all the PIIGS, they need more debt in order to raise the cash they need to pay off the old debt. They are simply not generating enough revenue to survive.

What do you call it, when a borrower has to take out more loans to pay off the maturing debts? A Ponzi scheme. ‘Nuff said.

Greece was on deck for more loans to pay off the old loans. The International Monetary Fund (IMF), the European Council (EC) and the European Central Bank (ECB) had put together a bailout package, coupled with Greek promises of austerity and higher taxes, as well as a complicated contraption to roll over some of the maturing Greek debt.

In the Grand Scheme which is the European Union, Greece is a bit player: It’s GDP is roughly a couple of percentage points of the whole eurozone—nothing to get into a twist over.

But the IMF, the EC and the ECB were getting into a twist over Greece—like an octopuss playing Twister, as a matter of fact—because of what Greece represented:

A firewall.

Greece needs a couple of hundred billion euros—but Italy has the third largest sovereign debt in the world, topped only by Japan’s and the United States’. Over $2 trillion of its debt comes due over the next five years. And Spain is not that far behind, if you add the regional debts of the autonomous regions, and the fact that the enormous Spanish banking sector is teetering, and will very likely need to be bailed by the Spanish government.

In short, Italy and Spain are simply Too Big To Bail-out.

Hence the troika—the IMF, the EC and the ECB—was trying its mightiest to bail out Greece and use it as a firewall to stop the sovereign debt crisis from spreading across the eurozone.

Too late: As of yesterday, Monday July 11, the tipping point was reached, insofar as market fears of Italy and Spain.

Monday was when Spanish 10-year bonds suddenly crossed the 6% yield mark, reaching highs not seen since 1997; the spread between Spanish and German debt is the widest in eurozone history. Meanwhile, Italy’s 10-year also hit records—5.67% yields—also records since donkey’s ears.

What happened Monday wasn’t a panic, precisely: It was more of a pre-panic. Think of it like a sharp tremor before The Big One: A taste of what a true sovereign debt panic would be like.

Now, why is this happening? That is, why is this happening now—what triggered it?

Nobody knows—and that’s precisely the problem. It could have been the ECB’s decision last week to raise interest rates 25 basis points to 1.5%—even as there is no inflationary smoke anywhere on the eurozone horizon. It could have been the IMF’s Christine Lagarde trying to sound tough over the weekend, saying essentially that all options were on the table with regards to Greece, including default. It could have been that some random bond salesman woke up gloomy because his football team lost on Sunday night, and spread his foul mood to his whole trading desk, and from thence to the entire eurobond market.

There are tons of explanations. But really, nobody knows why the eurobond markets swooned yesterday.

Ultimately, what triggered this swoon is a pointless question—like asking which of the last five straws broke the camel’s back. As it is, if it hadn’t been overloaded, this particular camel—or rather, this particular PIIG—would have been able to easily stand up to any one of those straws.

But on Monday, a tipping point was reached—the camel’s back was broken—the glass began to overflow: Pick your metaphor—the result is all the same:

The bond markets all now believe that Italy and Spain are in serious trouble—which is of course a self-fulfilling prophecy.

A lot of economists—Paul Krugman and his fluffer Brad DeLong are a case in point—swerve between dismissal of the so-called “Bond Vigilantes”, and berating them. But these none-too-clever fellows miss the point: The bond markets matter for the single, inescapable fact that they provide the money for the party.

The sovereign governments go out and offer their bonds to the market. And the markets go and buy their issuance—so long as the bond markets trust them.

But if the bond markets lose that trust—if they no longer believe that the money they lend is gonna get repaid—then they don’t buy the sovereign bonds. If they don’t buy ‘em, then the governments won’t have the cash to pay for the services they provide as well as pay for the maturing debt.

If the governments don’t have the cash to pay for their obligations, then they default—then they’re broke.

It really is that simple.

Monday was the unequivocal signal that the eurobond markets no longer trust Italy and Spain.

This Thursday, Italy is going to auction off 15-year and 25-year bonds. The chief economist of Citigroup and former Bank of England policy maven Willem Buiter thinks the ECB will simply have to step in and buy some of those bonds in order to prevent a failed auction—which could easily devolve into a full-scale panic at this point in time.

In other words, Buiter think that the ECB will have to begin to monetize the PIIGS’s sovereign debt, in order to avert a full-scale panic in the eurozone. This is major: Builter is plugged in, and he doesn’t hit the alarm button lightly.

This afternoon, however, Italy successfully auctioned off short-term paper, albeit it at yields of 3.67%, as opposed to the pre-swoon forecast of 3.1%.

So maybe Buiter is wrong: Maybe nothing happens on Thursday.

But actually, it doesn’t really matter—not after Monday’s swoon. It doesn’t matter if Thursday’s Italian bond auction goes smooth as glass or not: Monday was the signal that the markets have realized—in their bones—that the PIIGS are all broke, and that they will default, eventually.

The lack of a trigger for Monday’s swoon (or a “trigger” so trivial that it really is as slim as a single stick of straw) proves that the sovereign bond markets have no faith not just in Greece and Portugal and Ireland, but in Spain and Italy—the whales among the PIIGS.

For my Members at the Strategic Planning Group, I’ve already mapped out a detailed plan of what to do, once there is a sovereign default and the eurozone begins to break apart.

But the moment of when the eurozone would start to break apart? That was—I thought—in the indeterminate future: “Close, but not yet,” was my thinking.

Not anymore. Not after yesterday.

When a bond market swoons for no real reason at all, it’s a sign that the market participants realize they’re playing a game of musical chairs.

Therefore, the beginning of the end of the eurozone has arrived. It will happen imminently. And it could be triggered by anything—or like on Monday, by nothing at all.

Prepare accordingly.

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