Not even a full week has passed since the ECB obligingly announced a retooled version of its shelved Securities Markets Programme (SMP) and the market is already beginning to doubt Spain's commitment. The ECB crafted the 'new' bond buying plan to placate a restless market which, seemingly to the surprise of the central bank, took Mario Draghi quite seriously when he pledged to purchase short-end periphery debt at the beginning of last month. Draghi was largely successful in overcoming staunch opposition from Bundesbank president Jens Weidemann and ultimately managed to put forth a plan which, in word at least, addressed the concerns of everyone involved.
The plan paired a promise of 'unlimited bond purchases' with a feigned nod to inflation expectations (in the form of a promise to sterilize) and addressed the accusation of government financing by promising to confine its sovereign debt shopping sprees to short-end notes in the secondary market and tied the whole thing together by making participation contingent upon receiving nations' acceptance of EFSF/ESM conditionality. The market applauded, sending European stocks (as measured by the EuroStoxx 50) and U.S. equities (S&P 500) up around 5% and 2.3% respectively since the announcement of the plan.
Of course, the whole enterprise is contingent upon the willingness of Spain and Italy's proud leaders to make formal requests to the EFSF/ESM for aid. This would entail the signing of a memorandum of understanding with the rescue funds that would spell out the conditions to which the countries' must adhere to remain program-eligible. Italy's Mario Monti has already bluntly stated that Italy will not be requesting aid anytime soon.
While this is disturbing in and of itself considering Italy's economic situation, they are one domino removed from the debt crisis frontline. Spain is the immediate concern and, to no one's surprise who has monitored Spanish prime minister Mariano Rajoy's behavior over the past several months, it isn't at all clear that an aid request is forthcoming. While Rajoy has admitted he is considering the program, he seems to be in denial about the reason for the dramatic decline in Spain's borrowing costs over the past month:
It is completely ruled out that we would ask for a bailout for the whole country...the only option I am considering is using the central bank's announced mechanism...[but given current borrowing costs] I don't know if Spain needs to ask for it.
As he has done on several other occasions, Mr. Rajoy seems to be forgetting that the only reason yields on Spanish bonds have declined is because traders were rushing to front-run the ECB bond purchases. If Rajoy decides not to apply for aid because he is skeptical about the conditions it will entail in terms of more austerity, there will be no bond purchases and the market will quickly drive yields right back to unsustainable levels. Wall Street is already beginning to question Spain's commitment and Goldman Sachs has released a note to clients on the subject. Specifically, Goldman notes that
...current deliberations over Spain's agreement to conditionality suggest Spain is willing to push to the limit the market's tolerance...[and as such] the timing of any formal request will depend on market tensions.
Of course this is terribly undesirable. The ECB's intention was to promote stability with its new plan, not to trigger a new round of political brinksmanship. This was the danger in announcing a new program -- with the ECB promise in place, Spain sees no reason not to take a wait-and-see approach regarding market pressure on its borrowing costs. From Rajoy:
We will see how the risk premium develops and the financing differentials ahead.
As anyone knows who follows the crisis closely, there is no question as to how the risk premia will develop: in the absence of a formal aid request, yields will rise and the spread between Spanish debt and German bunds will once again blow wider.
Aside from these near term risks, Goldman also notes that there are significant medium term risks to Spain's delay:
The more the Spanish administration indulges domestic political interests and is perceived to be taking undue advantage of external support, the more explicit conditionality is likely to be demanded.
In other words, the longer Spain waits, the more offended the ECB and the eurosystem will become -- it took a considerable amount of effort and political wrangling to secure an agreement on the specifics of the new program and now Spain seems to be snubbing its nose at the idea. This virtually ensures that once the nation is finally forced by renewed market pressure to apply for aid, the conditions will be that much more stringent causing a concurrent deterioration in the country's political stability.
In sum, Spain has every reason to delay its aid application. New conditions would weaken Mr. Rajoy's political support and could exacerbate the severity of the recession. Additionally, it is in theory possible that the market will not be willing to pressure Spain's debt with the ECB backstop in place. However, given the ECB's loss of credibility over the course of the crisis, it is difficult to imagine that traders will not test the waters to assess whether the ECB is truly prepared to do what is necessary or even whether Spain will ultimately be willing to cede control of its fiscal policies to outside forces as part of an aid package. The level of uncertainty here is truly extraordinary. Given this, I recommend playing for renewed pressure on Spanish bonds and equities (EWP) as well as on European shares in general (FEZ). Additionally, it seems reasonable to assume that any indication that the ECB may not get the chance to test its new mechanism will lead to a spike in volatility here in the U.S. as renewed fears of a Spanish implosion test investors' nerves.