Predicting A Sell-Off: The Slow Death Of The Euro

|
 |  Includes: FEZ, FXE, GLD, SPY
by: Colin Lokey

According to former Goldman Sachs international advisor turned Italian Prime Minister Mario Monti, Italy has no plans to tap the ECB's new bond buying program. Monti discussed the matter with CNBC's Maria Bartiromo on Friday and in a brief article published Saturday, Bartiromo says the following about Monti's time as Prime Minister:

The prime minister has been able to stabilize the Italian economy and markets with his programs to raise taxes and cut spending as he seeks to balance the budget and rein in debt that is some 120 [percent of] the country's GDP.

Similarly, Bloomberg had this to say about Monti's effectiveness:

Monti burnished his credentials with bankers and business leaders since his November appointment by reversing a slide in Italian bonds and curbing speculation the government would need rescue funds from Europe.

These assertions are either misinformed or, more likely, disingenuous attempts to bolster Monti's image in the face of the deepening debt crisis. Either way, they serve as a nice setup to a discussion of why, after all the time and effort spent by officials, policymakers, media pundits, and commentators to craft and sell a new ECB bond buying program, it turns out the anticipated beneficiaries now want nothing to do with it.

Mario Monti was appointed head of a caretaker government in November after former prime minister Silvio Berlusconi resigned amid bond market turmoil. Although Bartiromo and others give credit to Monti for stabilizing the Italian economy and the market for Italian sovereign debt, in reality Monti has done neither.

Since Monti's appointment, Italian GDP has contracted by an average of .73% per quarter (compared to the previous quarter), the worst of any major eurozone nation save Portugal. Similarly, industrial production has fallen by an average of .88% per month (again, compared with the previous month) in Italy for the past six months, and according to data provider Markit, Italy's PMI fell to a ten month low of 43.6 in August as everything from output to new orders to employment fell. Consider the following chart which shows Italy's manufacturing PMI over time (Monti's appointment is marked with a green line):

Source: Markit

Finally, consider the following charts which show consumer confidence, consumer expectations for the economy, and retail sales in Italy (again, the green lines denote Monti's appointment):

Source: Italian National Institute for Statistics & Haver Analytics via NYTimes

Clearly, it is quite difficult to justify the contention that Mario Monti has stabilized the Italian economy. As for the second notion -- that Monti has helped 'reverse the slide' in Italian bonds -- consider the following chart which shows the yield on Italian 10-year notes with periods of ECB intervention identified:

Click to enlargeSource: Bloomberg

It would certainly appear that Mario Monti had very little to do with stabilizing the market for Italian sovereign debt -- significant spread compressions virtually always accompany ECB liquidity ops or jawboning. The moves at the short-end of the Italian curve over the past month are even more dramatic as a result of the short-end bias of the ECB's new bond buying operation.

This information is presented not to disparage Mario Monti but rather to illustrate an important point about the eurozone debt crisis. What the ECB has done by stepping in to boost liquidity and stabilize volatile periphery spreads is to delay the implementation of austerity in troubled eurozone nations. Austerity is painful and can exacerbate economic difficulties in the short-run. However, what widening spreads indicate is that creditors have grown weary of irresponsible and unsustainable fiscal policies.

When 10-year yields rise above 7% for a long enough period, nations are forced to institute fiscal reform rapidly, no matter what the short-term consequences in terms of economic hardship. If they do not, they will be unable to fund their governments in the bond market. By continually intervening with deed and word, the ECB is allowing problem countries to put off reform efforts by removing the funding pressure the market naturally puts on nations that implement bad fiscal policy.

With the incentive to change course thus attenuated, nations are free to implement half-hearted austerity measures designed more to appease official creditors than to remedy bad policy. But these irresolute measures aggravate deteriorating economic circumstances while conferring virtually no benefits due to the inadequacy of their scope and insincerity of their implementers. As a result, recessions deepen faster than austerity can return countries to fiscal sustainability.

In the mean time, the ECB continues to undermine the urgency normally conveyed by the sovereign debt market causing policymakers to see no need for radical reforms and no need to request a bailout. This is where Italy and Spain are now. Funding pressure has been relieved by ECB promises and time has been bought. The countries will now debate whether they should or shouldn't request aid and will also consider scaling back unpopular (but urgently needed) austerity measures. They will make just enough budget cuts to pacify their neighbors but not enough to make a difference and in three months, the cycle will start again as the ECB will be forced to talk down soaring yields.

In this way the eurozone is dying a slow and painful death. In the end, someone will default, someone will leave the currency bloc, and the euro will decline sharply as the world -- for a moment at least -- will lose confidence in the eurozone, its central bank, and its currency. Whether or not this event has long-lasting ramifications for the global financial system is a matter for debate. In my opinion however, the tipping point in Europe will come and there will be quite a bit of money to be made betting against the euro (NYSEARCA:FXE), against European (NYSEARCA:FEZ) and American equities (NYSEARCA:SPY), and for gold (NYSEARCA:GLD) and volatility, as the initial shockwaves will reverberate across the Atlantic. It is however, a question of timing and a question of what lengths the ECB is willing to go to preserve a fundamentally flawed system. I find that nearly everyone thinks the day of reckoning for Europe is near but nonetheless, sentiment remains remarkably bullish (U.S. stocks at four and half year highs). There is a fundamental contradiction there -- perhaps investors should take note of it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.