We are two days into the Grande Nouveau Regime, and it is already starting to look – well, not so grand.
The whole grand plan was ultimately designed to get sovereign bond yields of PIIGS down – and those of Italy in particular - since if those yields cannot be brought down, more PIIGS eventually be forced into a default situation and the entire EU economic area and financial system will collapse into a massive crisis.
The plan is not working.
Markets Not Playing Ball
Markets seem unimpressed by the “comprehensive plan” outlined Thursday morning. According to Reuters:
Italy's 10-year borrowing costs topped 6% for the first time since the launch of the euro more than a decade ago on Friday, as it held the first eurozone bond auction since European leaders agreed steps to tackle the debt crisis.
Analysts looked at the auction as a first important test of market reaction to the measures agreed at a summit on Thursday ...
Italian stocks widened losses after the sale with a trader citing the negative impact on investors' confidence of the psychologically sensitive 6% level for 10-year yields ...
The 10-year yield gap between Italian and German bonds widened after the auction to 378 basis points, about 10 bps wider on the day ...
Italy has managed to push through all its auctions since coming to the fore of the debt crisis in early July, but rising funding costs have brought into question the long-term sustainability of its debt, which is running at around 120% of gross domestic product.
Italy paid 6.06 percent to sell its March 2022 BTP bond, versus an average rate of 5.86 percent at an auction a month ago, also a euro lifetime high.
Three-year auction yields rose to 4.93%, the highest since November 2000, compared with 4.68% a month ago.
But shouldn’t the bond markets be optimistic now that the EFSF is coming to Italy’s rescue with guarantees? As I pointed out here, bond markets are not dumb. The EFSF guarantees - even if they were credible, which they are not - will only apply to newly issued debt. The old debt is left to twist in the wind.
Most importantly, the real “risk free rate” for Italy – the real benchmark rate which all other internal interest rates in Italy will price off of – will be the yield on the unguaranteed debt and/or the “stripped yield” of the new guaranteed debt.
As I have explained previously, there is no reason to suppose that these yields will decline. Italy’s sovereign credit fundamentals have not changed one bit. Its debt is still 120% of GDP, the economy is uncompetitive, and the growth is sclerotic.
What bond global markets are signaling today is that the credit risk of Italy’s sovereign debt has not diminished by one iota as a result of the grand deal struck on Thursday morning. If anything, the fact that the bond yields were priced at an all time record yield suggests that market participants believe that risk has increased since the grand deal struck on Thursday morning.
Global bond markets are not playing ball.
Things are not well in Europe. The new regime is not even two days old and already it is being riddled with holes.
If the sovereign bond yields of Italy and other PIIGS cannot be contained quickly and brought down substantially below the levels that they were at prior to the grand agreement on Thursday morning, all bets are off for Europe. All bets would be off for the global relief rally as well.
One would think that an unraveling of the “comprehensive” plan agreed to on Thursday would take weeks or months. But a few more results like Italy’s recent bond auction and the whole scheme could collapse before it is ever even implemented.
The S&P 500 (^GSPC) has cleared most key resistance levels and has little to hold it back from a technical point of view. The area around 1,300 is the only resistance before the market retraces its entire decline since July.
I will repeat what I said yesterday: This set-up reminds me a great deal of what occurred after the initial Bear Stearns and sub-prime related plunge of equity markets in mid 2007. After the initial correction, markets swiftly rallied back to new highs despite the fact that any serious analyst could see that the entire U.S. financial system and economy was in the midst of an enormous collapse. I believe that a similar situation now exists with respect to the situation in Europe. If you are an investor with a medium to long-term time-horizon, I would stay away from stocks - even stocks like Apple (AAPL) Intel (INTC) and Microsoft (MSFT) that look tempting at these levels.