As the new year approached we have seen a lot of predictions for 2011 being made. I am throwing my own hat into the ring and stating what I feel is an easy prediction. One of the members of the eurozone currency bloc will default within three years. By creating a perpetual bailout fund and showing that they will not impose haircuts on holders of bank debt, the eurozone has sealed its own fate. The moral hazard it has created virtually guarantees that profligate countries on the euro will not do the right thing. They will not cut spending to the levels that reduce their debt levels to any significant degree.
One thing that we’ve seen with the collapse of Greece and Ireland is that events unfolded quickly. Bond investors seemed to be asleep at the switch until it became absolutely clear that both countries were headed for default. Interest rates skyrocketed in just a few months. At the beginning of 2010, Greek 10 year yields were hovering around 6%. They now sit at 12.5%. Similarly, Ireland’s 10 year yield at the beginning of 2010 was 4.5%. Now it is 8.14%.
Looking at the table above, we can see that Italy is going down the same path as Greece and Ireland. Debt to GDP is already over 100% and their deficit to GDP is twice that of Germany. Yet their 10 year government yield sits at only 4.8%. Do investors really think Italy will get its fiscal house in order? It won’t happen. Watch for Italy’s bond yields to soar in 2011.
As for Spain, their debt is not nearly as onerous as some of the other member countries. But their deficit is. With deficits as high as Spain’s, the interest compounds quickly. If Spain doesn’t cut its deficit, its debt to GDP ratio will above 100% in only four years.
One important thing to keep in mind is that Italy and Spain have economies that are over 10 times the size of Ireland and Greece. A bailout of Italy or Spain will spell the beginning of the end for the euro. No way can Germany support a bailout of either country. If their citizens don’t stop it, the bond markets will. German interest rates would begin to climb, removing the final card holding the entire house of cards together.
Defaults are going to happen in the eurozone. At that point, look for stocks across Europe to get hammered. After the defaults begin there may be a buying opportunity. But until then, stay away from countries on the euro.