You might not know it from looking at the U.S. stock market, but Spain and Italy are the closest they've been to outright defaults since the EU debt-crisis began.
On Tuesday morning, Spanish 10-year yields were as high as 7.65%, while Italian 10 years were trading at 6.47%. Far more telling was the action in shorter-term debt, as Spain's 2-year bond yields soared to 6.65%, and Italy's comparable bond yields rose over 6% to 4.93%.
Weakness in shorter-duration bonds to this extent indicates that a real crisis is in the works. While Italy saw even weaker demand for its debt back in November of 2011, Spain is in new territory.
Massive Capital Raise Needs
For the remainder of 2012, Spain needs to go to the market for at least 35 billion euros. While this is quite a difficult task to begin with, should Spain not meet its "projected" fiscal deficit (does it ever?), the total funding need will be far higher. Finally, the 35 billion figure does not take into account the several billions that Spain's heavily indebted regions need for their own funding gaps. Completely shut out from private debt markets, the regions are dependent on the central government to borrow at unsustainably high rates of interest and pass on the proceeds. The total capital need for Spain may be 100 billion euros when all is said and done.
Spain's CDS now trade at 636, implying a default risk of 42.5% in the next 5 years.
Italy plans to issue 120 billion euros of debt, the majority of which to be in shorter-duration bonds. The Italian 6-month bond yield rocketed 30% higher intra-day on Tuesday morning, up 57 basis points to 2.53%. Such heavy selling in short-term debt reflects a dramatic repricing in near-term default risk. Let's not forget, however, the 6-month bond yields were higher than 7.50% at peak of the crisis in November 2011.
The last quote I was able to obtain for Italian CDS showed 5-year CDS trading at around 550.
With the ESM now out of the picture until at least September, and the EFSF strapped for cash after factoring in the Spanish bank bailout, the public assistance picture is extremely murky.
IMF To The Rescue?
The IMF's so-called "war-chest," which Christine Lagarde has been so proud of, totals about $450 billion.
A full-out sovereign bailout of Spain would require at least $350 billion, and probably much more once regional debts and other liabilities are factored in. Politically, and physically, a full Spanish bailout from the IMF alone isn't feasible.
As already explained, the EFSF will be of little help, and the ESM doesn't even exist yet.
Let's say the IMF did in fact bail Spain out, essentially draining all of its (and probably the remaining $150 billion in EFSF funds) cash; Italy would sink overnight. With no cash left, the Italians would be left out to dry, and then we'd have a real crisis. The conclusion, which has been known (but ignored) for quite sometime, is that there is not enough money to bail out every country that needs assistance.
How About The ECB?
Last Summer, as Europe (quietly) teetered right on the edge of collapse, the ECB stepped in and purchased 211 billion euros worth of sovereign debts.
Spain is all but begging for the ECB to announce some sort of yield-capping, for all the structural good that would do. However, the WSJ points out that doing so would require an "open-ended buying commitment" and would "create a political firestorm." To say the least.
Toward the end of last year, to really distort risk pricing (just ask JP Morgan), the ECB implemented its first round of LTRO. This has been pointed to as an option to calm markets, but once again, questions regarding collateral and the risk that the ECB wants to assume linger. Additionally, another round of LTRO is certain to make the next flare up even worse, since each new injection kicks off the so-called carry-trade whereby banks load up their balance sheet with risky sovereign debts.
So, What Does "Finished" Mean, Anyway?
Market participants should never underestimate the ability for central planners to keep their structurally flawed "union" together, but each new flare-up in this ongoing crisis draws us closer to the end-game of major debt restructurings or sovereign defaults.
Debt restructurings should have already happened, however, and the window for that may now be closed. Countries like Spain, Italy, and Portugal, should have taken the opportunity in early 2012 to restructure hundreds of billions in debt with their creditors, when markets were awash with free cash and able to handle it.
At this point, I expect controlled defaults from Spain and Italy by the end of 2013.
Spain's real debt to GDP ratio is almost 150%, while Italy's is 120%. With both countries planning on going to debt markets for tens of billions in new funding this year alone, these ratios (and the subsequent funding costs) are going to expand markedly by next year.
As the eurozone economy continues to aggressively contract (shown in last night's PMI data) and capital moves rapidly to perceived "safe" assets, Spain and Italy are likely to be basically shut out of the debt markets by early 2013. No one trusts their fiscal targets, and traders are watching their underlying economies for further evidence that tax revenue is weak.
We are indeed entering a new stage in the euro-drama; never before have we seen so many issues to deal with at once. It has typically been Greek worries, or Portuguese default risk, or the like. This time, the ECB is out of bullets, the EFSF is drained, the ESM doesn't exist, and the IMF doesn't have enough cash to fully fund the bailouts of both Spain and Italy.
"Tuning out" Europe seems to have been the theme lately. Every time it seems like the union is going to come apart, someone gets bailed out or trillions in cash gets printed, and every big bear gets skinned. The big funds have mostly lost the desire to speculate on a European collapse, and instead have simply entered the crowded short-euro currency trade.
Regardless, with U.S. equities not even 5% off their 2012 highs and earnings growth having slowed markedly, the risk/reward profile is skewed very favorably for shorts.
My thesis has rounded out a bit in the past few weeks: while the risk of a major U.S. equity collapse is exceptionally slim, there is an apparent mis-pricing of risk, as seen in the divergences between broad risk assets and U.S. treasuries.
I recommend trades that take advantage of being short the S&P (SPY) but allow you enough time for risk to be adequately repriced into valuations.
Additional disclosure: Short via puts