Spain and Italy decouple - an incentive for the ECB to sit back?
As Spanish bond yields soar, the deadly coupling between Spanish-Italian sovereign yields seems to have cooled – potentially reducing the prospects for much-needed monetary aggression from the ECB as market turmoil shows no sign of abating.
So there’s good news, and there’s bad news. The good news is that Italian bond yields aren’t joining Spanish yields in their journey upwards. The bad news is that a spike in Italian yields is the catalyst that will push the ECB to take much-needed drastic action - such as quantitative easing with a yield target - to arrest the free-fall in markets. As one trader told Euromoney, "if short-term Italian bond yields spike, the ECB will have to act". After all, let’s not forget that it was the concern over Italy's solvency that pushed Draghi to cut interest rates last November, shortly after becoming ECB president. Sober Look has a nice take at the widening spreads between Italian and Spanish 10-year bonds. Essentially, it looks like that Spain’s dysfunctional banking system and a bailout that is being viewed as a damp squib have caused investors to re-assess the relative creditworthiness of Rome and Madrid despite Italy''s debt mountain and rollover needs.
|Italy 10y yield minus Spain 10y yield, courtesy of Sober Look.|
Even if investors have a good reason for fearing Spain more than Italy, it certainly breaks with past form. As BCA Research has noted, this year, Spanish and Italian bonds have been more or less perfectly correlated.
Meanwhile, the researchers over at Exotix have some rather frank words for eurozone leaders, whom they expect to provide the new Greek government with a few minor concessions - but nothing that will help Greece to deal with its broken fiscal situation:
To secure a more durable path, something more radical and generous is needed from Europe to restore confidence in Greece. The golden rule of crisis resolution is to provide upside, in order to build a constituency for painful reforms in the debtor country and to catalyse investors to invest, bankers to lend, workers not to strike. We think Europe may get to that point but not yet. Europe has, to date, never come up with a programme that had more than an outside chance of working.
It would, in our opinion, be a crazy decision for Europe to incur the costs of a Greek exit, but politicians do indeed sometimes make crazy decisions. The costs to Europe of a Greek exit are huge; the direct costs, financial contagion and contagious bank runs. The scariest of all is the likely form of any exit being Europe pulling the plug on the Greek banking system. Let us be clear, this would be an extremely violent economic act with horrible short-run consequences for Greece. Imagine if US could threaten Iran with closing down its banking system. You would never need the threat of sanctions or indeed military action.
We think the most likely scenario is that at some point in the next year, Greece will return to the brink, and Europe will have to blink, providing a more generous deal. But we recognise there are a host of other (almost equally plausible) scenarios, some more positive, others more negative.
Even if Spain is looking bad, at least they can take some comfort that Greece still seems to be in a worse situation. Talk about a pyrrhic victory.