Any relief over the Greek elections earlier this week completely bypassed the Spanish bond market. The ten-year yield on Spain’s bonds went above 7% earlier this week, the level which many view as “the point of no return”.
The cost of insuring against a Spanish default in the next five years also increased, and is now over 600bps. Yesterday’s auction of Spanish bonds also went badly. Although the government sold its stated target of $3bn, it did so at sky-high interest rates. Indeed, the rate on one-year bonds was over 2% higher than it was a month ago.
So do these spiking yields mean that a default – or yet another bail-out – is inevitable?
Why bond yields are rising
The immediate reason for the rise in Spanish bond yields is concern about the banking system. When the European Union (EU) gave Spain a $100bn loan to bail out its banks it asked it to carry out a bank audit. However, Madrid has now decided to delay it. This has raised suspicions that Spanish banks are in even more trouble that has been assumed. Indeed, the percentage of bad loans has risen to 8.72%, an 18-year high.
At the same time, people are pulling deposits out of banks. This means that $100bn, which Madrid always claimed was a high figure, may not be enough. Alberto Gallo, senior European credit strategist at RBS, thinks that “Spanish banks will need to generate €134bn of capital over the next three years, on rising bad loans and increasing regulation”.
So why does it matter? As bond yields rise, the more expensive refinancing debt becomes. In turn this will push up the deficit (the country’s annual overspend) – making it harder for countries to bring the overall debt under control.
In the worst case scenario, this cycle can quickly spin out of control, with soaring rates and debt feeding off each other. If interest rates get too high, then Spain will be forced to either seek EU help or default – similar to what happened to Greece.
Capital Economics thinks that the second option – defaulting – is “virtually inevitable”. However, it is not clear what the terms will be. Indeed, “there are major uncertainties over the likely size of such a bail-out, how it would be financed and what resources would be left to meet the requirements of other troubled countries”.
Is Germany really going to budge?
One cynical view is that Spain’s plight will force the EU to drop any pretence of imposing further cuts. Having pledged so much already it can’t afford to admit that it made a mistake. The idea of a ‘banking union’, where the EU as a whole, rather than individual countries, bails out banks is gaining popularity. Indeed, the G-20 summit has agreed that, “Euro Area members of the G20 will take all necessary measures to safeguard the integrity and stability of the area”.
Meanwhile, today’s papers are filled with reports that Germany has agreed that the European Financial Stability Facility (EFSF) will be allowed to directly buy bonds of heavily indebted countries. As much as $600bn of EU cash could be used, with the aim of driving down Spanish, Italian and Greek interest rates.
However, this may be a step too far. Germany has not formally agreed to the use of the EFSF – only to “discussions”. Indeed, these leaks about possible action are so vague that they may be a bluff designed to boost confidence.
If the deal does take place, Angela Merkel will have to explain her action to her coalition partners who are pushing her to stand firm. Germany’s highest court has also ruled that parliament must also approve any deal. Ironically, Berlin is also insisting that its regional banks be exempt from any “banking union”.
Will the euro fragment?
So, it looks as though the rising Spanish yields are a vote of no confidence in the future of the euro – as well as Spain. As Nicholas Spiro of Spiro Sovereign Strategy puts it, “the crisis is increasingly no longer about Spain. It’s about the fear that the eurozone is going to fall apart because of the absence of a fiscal and banking union. The market has become increasingly binary: backstop or break-up”.
A break-up would not necessarily be bad news for the southern European countries. Devaluation would enable them to become more competitive in a quicker and potentially less painful manner. It would also act as the spur for the ECB to take concrete measures to boost the money supply in the rest of the eurozone.
However, with politicians unable to accept the notion of either a break-up or a fully-blown, decisive union as yet, we suspect there will be many more spasms of panic for markets to endure before the eurozone crisis comes to any sort of conclusion. My colleague John Stepek looked at what investors can do about this in today’s Money Morning.