Contrary to popular belief, ECB purchases of Spanish and Italian short-term debt are by no means a foregone conclusion. Over the weekend, Belgian bank governor Luc Coene observed (correctly) that the sovereign debt market serves as a check on government excess:
"The conclusion is clear: When you take away the market pressure, you take away the pressure on politicians to act."
When government debt reaches unsustainable levels, investors demand more money to take-on the risk that debt entails. Eventually, the amount investors demand exceeds the amount the government can pay, and spending must be cut if the government hopes to retain access to debt markets.
Coene argues that by purchasing the bonds of countries that refuse to exercise fiscal restraint, the ECB is rewarding bad behavior. Coene's comments serve as a reminder that there are several hurdles that need to be cleared before the ECB can reactivate its bond buying program, not the least of which is resistance from the eurozone core.
Monday a new lawsuit was filed in Germany challenging the constitutionality of the European Stability Mechanism. The new suit could delay the ratification of the ESM by several more months and Europolis (the think tank that filed the suit) is seeking to have the case heard before the European Court of Justice, an eventuality which could delay the rescue fund's ratification indefinitely.
On top of this, it is by no means clear whether Spanish Prime Minister Mariano Rajoy or his Italian counterpart Mario Monti will accept the aid they so desperately sought just under a month ago. It appears that the decline in the two countries' short term borrowing costs occasioned by Mario Draghi's suggestion that the central bank could restart its bond buying program has emboldened the two leaders to a degree that many consider to be imprudent.
Rajoy for instance, has indicated he will need to review the conditions attached to any potential rescue plan before deciding whether it is appropriate, and Monti has explicitly stated that all Italy needs is 'moral support.' The real test will be how the two leaders react in the event their countries' short-term borrowing costs abruptly spike again. Yields have already began to creep back up as Spanish 2-year yields are up 86 basis points (as of Monday) since hitting a low of around 3.38% on August 6, and Italian 2-year notes have risen around 44 basis points over the same period.
Meanwhile, investors are apparently oblivious to the risk and have piled into European investment grade credit. According to ZeroHedge, clients are expressing a record net bullish position in the iTraxx Europe. Additionally, European bond spreads have fallen back under CDS spreads in yet another example of the market's outright denial of reality.
Given the increasingly uncertain timeframe for the ESM activation, these bullish positions seem to be based more on hope than fundamentals. It is reasonable to assume that these spreads (Italian and Spanish 5-year-and-in and 5yr CDS) will widen again in fairly short order. If investors don't care to place bets on Spanish or Italian debt and/or CDS, a decent substitute (because a rise in periphery yields and CDS spreads would indicate a decreased appetite for risk) could be a bearish position in European equities (FEZ) and specifically European financials (EUFN) and/or a long position vis a vis volatility.