Throughout the eurozone debt crisis, European officials have time and again proven their determination to stick to short-term solutions -- "can-kicking" if you will -- while demonstrating a steadfast refusal to face the long-term reality that fiscal irresponsibility leads nations to ruin. Yesterday, the ECB took shortsightedness to a whole new level when Mario Draghi explicitly stated that any ECB bond-buying would focus on the short end of the yield curve.
Effectively, the ECB is set to implement Operation Twist in reverse, except the central bank will only be actively participating in one leg of the trade. No matter, private investors will take care of the other leg of the trade for the ECB now that Mario Draghi has made it clear that Spain's long-term financing needs are of no immediate concern:
The ECB's proposed purchases will actually steepen the yield curve as short term yields are driven down, but long term yields continue to climb, as no structural changes have been made to make investors more confident in the financial future of the Spanish state.
The inevitable result of this move by the ECB is a flood of money into Spanish 2s as investors rush to front-run Draghi, while perplexed holders of long-term Spanish debt are left with no logical choice but to sell their notes, as it appears policymakers have simply given up on Spain's ability to survive over the long haul without a troika-assisted bailout. As one strategist quoted by the Wall Street Journal succinctly put it, "This steepening could encourage sovereigns to further shorten the maturity of their debt, which is not conducive to long run stability."
While the spread on the Spanish 10-year note has come in considerably during today's session, tightening around 30bps, yields were wider by 40bps yesterday, meaning the net effect has so far been negative. It should be noted that earlier today, yields were higher by as much as 25bps, indicating investors' initial angst at the precarious situation.
More importantly, yields on Spanish 2-year bonds are down nearly 90 basis points in today's trading alone. All of this points to a wholesale abandonment of Spain in the long-run, and an implicit concession that a bailout will eventually be necessary. The ECB's sole purpose is ensuring that Spain can fund itself in the short-term, thus preventing a panic.
Unless investors happen to have owned Spanish 2s going into Thursday, this does them absolutely no good. It virtually assures that the ECB will do nothing to prevent a Spanish bailout request, meaning that such an event (and the systemic risk that comes with it) is now more likely than ever. In fact, JPMorgan's Ginaluca Sanford recommends the following trade:
...we recommend re-entering shorts in 10Y Spain. We target a 10Y yield level of 7.75%, vs. current levels of 7.12%. Spain reached 7.75% on an intra-day basis in late July, and was trading near this level prior to Draghi's comments last week...We also recommend closing our 2s/4s Spanish curve flatteners.
The obvious implication here (and one that ZeroHedge also points out) is that at 7.75%, the trade should be exited because that is about where Spain will be forced to request a full-blown bailout. Ultimately, there are two trades here: short Spanish 10-year bonds and short both U.S. (SPY) and European (FEZ) equities. Both assume that a Spanish bailout will materialize, as there are now no impediments to the relentless pressure on Spain's long term borrowing costs. When Spain does request a bailout, it will likely be met with a whirlwind of uncertainty and skepticism, begetting volatile trading and falling stock prices.