Let's be clear: the jubilation exhibited by investors in European equities and periphery bonds is misplaced and has created a sucker's rally. Spain's IBEX rose 2.4% Wednesday and shares of Bankia, the country's large nationalized lender, leaped nearly 20%. The EuroStoxx 50 hit 2,569.83, its highest level since September 25. Partially responsible for the rampant and irresponsible optimism is Moody's decision not to follow in S&P's footsteps in downgrading Spain.
Moody's rationale for not cutting Spain to 'junk' status was, ironically, that the ESM and the ECB are willing to prop up the market for Spanish sovereign debt. As I noted in a piece published elsewhere Wednesday, the idea that a country's likelihood of receiving assistance from a rescue vehicle and a central bank is somehow indicative of its being more creditworthy is the definition of absurdity:
...saying that entry into an ESM funded program won't lead to a downgrade as long as Spain retains access to 'private capital markets' is nonsensical. If Spain had sufficient and meaningful access to private capital markets it would not be enrolling in an ESM program.
Furthermore, as the Wall Street Journal notes, by not downgrading Spain to junk, Moody's has probably delayed Spain's aid request. That is, by its (in)action, the ratings firm has made less likely the very event it used to justify not downgrading Spain:
Moody's suggested a big part of its decision was that Spain would probably apply for official aid from its euro-zone partners...Madrid may well apply for this help...but as long as Spanish bonds remain at investment grade, Spain has less incentive to ask for assistance.
One thing is clear: the words or actions of the ECB are not 'sustaining' demand for Spanish debt as Moody's would have the market believe. There is no demand left to sustain. Indeed the very reason the ECB is taking unprecedented steps is because demand for Spanish bonds dried up so much in July that the Spanish yield curve inverted.
This is something international law firm Cleary Gottlieb no doubt understands as evidenced by a paper written by one of its lawyers Lee C. Buchheit in conjunction with noted Duke Law Professor G. Mitu Gulati entitled "The Eurozone Debt Crisis--The Options Now". Buchheit and Gulati describe ECB and ESM involvement as follows:
...intervention in the primary or the secondary markets in order to suppress the yields on a debtor country's paper and thereby permit continued access to market borrowings at tolerable coupon levels. [Emphasis mine.]
Contrast this with Moody's characterization:
...the willingness of the European Central Bank (ECB) to undertake outright purchases of Spanish government bonds to contain their price volatility...should in turn help sustain demand for Spanish government bonds. [Emphasis mine.]
As indicated by the highlighted terminology in the above cited passages, the realistic characterization of the current situation is that the ECB and ESM are making it possible for Spain to borrow -- they are permitting it. In the more charitable characterization, demand for Spanish debt is there, the ECB and ESM are simply working to ensure that existing demand is sustained. This is a critical distinction as it would be quite difficult to justify not downgrading a country's debt if the only thing keeping yields on its bonds from skyrocketing was official sector intervention.
When there is existing demand, a country may be able to continue to borrow, just at elevated (but still tolerable) rates. When the only demand that exists is demand either from a central bank/rescue vehicle or derived from a desire to front-run official sector purchases to make a quick profit, the debtor country will likely lose all market access in fairly short order as, contrary to popular belief, the central bank is incapable of supporting the market for an extended period. From Buchheit and Gulati:
...the track record for official sector intervention to massage yields on sovereign bonds is not good. In the early days of the European debt crisis, the ECB intervened in the secondary markets to buy Greek, Irish and Portuguese bonds. The effort failed in each case to preserve market access for more than a few weeks or months.
In the case of the ECB's OMT plan, the effort to suppress yields by purchasing bonds in the secondary market will invariably fail again. The reason why is simple and it is something I have been saying for quite some time but which only recently is being taken seriously by the masses: central bank mark-to-market losses matter, even if not strictly in terms of the balance sheet, undoubtedly in terms of the political will to support the central bank's actions. As Buchheit and Gulati put it,
...the markets may mercilessly test the ECB's willingness to persist in buying unlimited quantities of peripheral sovereign bonds. And every time a prominent politician in Germany or elsewhere, perhaps goaded by an ECB report of an eye-watering mark-to-market loss on OMT-acquired bonds, rails against the OMT program, the shorts will be emboldened. They will constantly be measuring the amount of political rope left in the ECB's coil.
Furthermore, the lawyers note that by activating the OMT program the ECB could paint itself into a corner in terms of an exit strategy in the event a program country fails to implement the promised austerity measures. In short, program countries might well decide that it is politically expedient to drag their feet regarding the institution of painful budget cuts. After all, the ECB is unlikely to cut a program country loose, because if they did, the mark-to-market losses on the existing periphery bond portfolio could bankrupt the central bank:
Rather than abruptly suspend further OMT purchases to a non-complying country, with the predictable consequence of an immediate spike in yields and massive mark-to-market losses in the OMT portfolio, the Europeans may feel that they have little choice but to accede to whatever relaxation of the adjustment program is demanded by the debtor country. [Emphasis mine.]
Of course this isn't desirable either as the very reason the periphery lost access to the bond market in the first place was its general lack of fiscal restraint. If periphery nations participating in the OMT program were to decide that the ECB had no choice but to continue to purchase bonds, these countries might well continue to demonstrate shortsightedness in terms of fiscal policy. This would lead to a situation wherein investors will continue to demand higher premia for the countries' bonds which will in turn cause mark-to-market losses for the ECB, all the while necessitating more OMT purchases which themselves will incur losses, and around we go.
No matter how many ratings agencies attempt to sugar coat the situation and no matter how many official sector promises regarding the 'indissoluble' nature of the euro are made, investors can be sure that this situation will end badly. There simply is no way out save the painful implementation of austerity over the course of several years in the periphery. Investors should view the recent rally in European equities and peripheral debt as an opportunity to capitalize on Europe's eventual day of reckoning. I recommend betting against European equities (FEZ) (EWP) (EWI) (EWG), for volatility (VXX), and against periphery sovereign debt.