At the moment of writing (Monday morning) Spanish yields are above 7%, that's clearly not sustainable for an economy with 25% unemployment, a property bust, a banking crisis and a deep recession cutting severely into tax receipts.
While Spain could, in theory, keep funding itself at these rates for quite some time, this clearly puts them on an unsustainable public finance path, so realistically, something has to be done pretty soon, but what?
First of all, one has to realize that this crisis is to a large extent systemic. Spain had a budget surplus and half the public debt/GDP ratio that Germany had in 2007. The Spanish housing bust and subsequent deleveraging of household and bank balance sheets is producing the savings that would normally keep rates low in Spain, as it does in the UK.
The fact is, Spanish savings can flee to Germany without incurring any exchange rate risk. Indeed, if you're really pessimistic and see Spain leaving the euro, there is every incentive to park your money there. Hence you see the capital outflow from where it's needed to where it's not needed (German yields are on record lows already).
And if something isn't done pretty soon, these perverse capital flows just keep on going, gravely undermining the sustainability of Spain's public finances, and with that, the continued existence of the whole Euro zone will become quite problematic. So it's clear something should be done, but what?
European Central Bank
In theory, the institution that is most qualified to deal with this problem is the ECB. It already has purchased some 200 billion in Euro zone public debt, but has stopped doing that. One thing one has to remember is that other central banks, the Fed, the Bank of Japan, the Bank of England, have no problem with this operation.
But things in Euro land are a little bit different. The main objection was worded by former ECB policy maker and economist Bini Smaghi. The ECB should keep up the pressure on countries to reform and cut budget deficits. That's all fine and understandable, but they should reward good behavior as well. That would double the incentive and provide light at the end of a really long, dark tunnel.
In Italy especially, there is scant understanding of this position (despite Mr. Bini Smaghi, and of course Mr. Draghi, the ECB president being Italian). Mario Monti is doing what he can in terms of reforms and budget cuts. Things that were impossible for a long time, like reforming the labor laws, has suddenly become possible.
But where is the reward for those efforts? Italian bond yields are above 6%, clearly not sustainable either with a shrinking economy and a public debt/GDP ratio in excess of 120% already. Like the Spanish, they must feel there is nothing they themselves can do to bring these rates down. And indeed, there is little they can do. The crisis is largely systemic.
That leaves the ECB, as the ESM (the permanent rescue fund) is still not up and running and is too small anyway to prop up Spanish banks and Spanish and Italian bonds. But they're in no hurry whatsoever.
One could argue that the continued climb in Spanish and Italian yields is because of their economic outlook (which is very bad, needless to say) or because of the fact that the latest Euro summit results (steps towards a banking union and allowing the ESM to buy debt directly in primary and secondary markets) are not iron clad, with the Finnish and the Dutch somewhat revolting and Merkel having a lot of explaining to do at home.
While for most observers anywhere, a banking union is a pretty straightforward and necessary step towards containing the crisis, one has to keep in mind that in Germany itself, it's highly controversial. One of Germany's leading economists, Hans-Werner Sinn, together with like-minded economist scolded the idea, even provoking a counter manifesto by German speaking economist.
But it really remains to be seen whether full implementation and backing of these results will restore confidence in Spanish and Italian bonds. We fear that while these measures are useful and necessary, they're not going to be enough. It is one thing to have severed the destructive loop between banks and sovereigns, but other feedback loops remain.
Capital flight from the periphery towards the center simply put peripheral yields on an upward trajectory, which makes getting the public debt under control that much harder, which provokes more capital flight. This isn't something theoretical, but happening right now.
Another negative feedback loop is between austerity and growth. Hiking taxes and cutting public expenditure clearly hurts economic growth, now well and truly negative in the periphery. Negative growth and 7% interest rates together clearly put public finances on an unsustainable path. Something has to break these vicious cycles, but what?
There is some relief from the ECB. It cut the deposit rate to zero in a step that, according to the Dutch Rabobank, is clearly aimed at depreciating the euro:
a zero deposit rate shifts the goal posts in terms of demand for the EUR and as we argued on Friday is likely to underpin interest in higher yielding diversification currencies. The ECB can now be accused of being a player in the "currency wars" - a field that to date has been dominated by players such as the SNB, the Fed, the BoJ, the BoE and of course the Brazilian central bank. [FT Alphaville]
Well, that helps. But since much of the rest of the world is already pursuing these kind of policies and economic growth is decelerating nearly universally, it remains to be seen how useful this is going to be.
What is potentially more significant is that the misalignment in intra-Euro zone competitiveness is reversing, albeit slowly. The capital inflows in Germany have put upward pressure on inflation, wages (unemployment is the lowest in decades) and house prices, while the reverse is happening in much of the periphery, where wage cuts and productivity increases redress some of the lost competitiveness.
But this is a slow and grinding process that takes years to undo what went wrong in the previous decade. In the end, the Euro zone might well re-emerge as a more competitive area on the world stage, but whether we're getting there before some of the vicious cycles have exploded the whole area to smithereens remains very much to be seen.
In the meantime, bet on a lower Euro through some of these ETF trading vehicles. Shorting the plain vanilla ones like CurrencyShares Euro Trust ETF (FXE) or EUR/USD Exchange Rate ETN (ERO), or take on more adventures vehicles like shorting the 2x leveraged ProShares Ultra Euro ETF (ULE) or Market Vectors Double Long Euro ETN (URR).
If yields spiral out of control in Spain and/or Italy, which must count as a distinct possibility, the hand of the ECB will be forced. Keep in mind that if there will be countries exiting the euro (which we can't at all exclude), you won't be the first to hear about it, and this would be quite bullish for the Euro.