In an article published last month entitled "Fool's Rally: Moody's Backward Logic Triggers EUphoria", I noted the illogicality in characterizing an impending Spanish bailout request as a good thing in terms of credit worthiness:
"...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."
On October 16, Moody's determined not to take Spain's sovereign rating into junk territory because, in the parallel universe that has become the eurozone, enrolling into a central bank-sponsored bailout program is somehow a viewed as a positive development. Of course, as the Wall Street Journal noted at the time, the very act of not downgrading Spain would invariably serve to delay the country's bailout request upon which the decision not to downgrade was based in the first place.
Three weeks later and these suspicions have been confirmed -- there has been no bailout request and, according to Spanish Prime Minister Mariano Rajoy, none is forthcoming. In a speech before Congress Rajoy recently had the following to say regarding his failure to grab hold of the life raft thrown his way by the ECB:
"Sometimes there is no decision more difficult than not [making] a decision."
Indeed. Meanwhile, the bond market is losing its patience as everyone knew it would. The only reason the risk premia came down so dramatically was that traders were looking to front-run ECB purchases. If no such purchases are coming because Rajoy refuses to request a bailout, yields will leak higher. Proof of this is already evident. Consider for example the following chart which shows the spread between the yield on Spanish 10-year bonds and comparable German notes:
As you can seen, the risk premium has risen steadily since the Moody's announcement as it has become readily apparent to nearly everyone that the event Moody's relied upon to justify its inaction simply isn't going to happen anytime soon.
This makes it all the more ridiculous that Rajoy would say the following about the prospects for a bailout request:
"How far will the risk premium fall [with a rescue]? If it stays at 400 basis points and does not drop to 200 basis point...then there is no sense"
It is as if the Prime Minister really doesn't understand that the risk premium was below 400 basis points -- before he decided to delay the bailout request. Now, the spread has crept back above 400bps and he is essentially citing this as a reason not to capitulate. Someone should inform Rajoy that while there is no guarantee that the ECB will be able to bring the risk premium down to 200bps, one thing that is guaranteed is that the spread will continue to widen if he doesn't enroll in the OMT program.
Additionally, the spread between German and Spanish 10-year notes hasn't been below 200bps since April 15 of 2011 and it isn't reasonable to ask the ECB to target a specific spread. Recall that so-called 'rate caps' (which is essentially what Rajoy is asking for by referencing a specific spread) were abandoned in mid-August as a possible solution to the discrepancy between yields in the periphery and yields in the core.
As I noted in August, one of the main problems with this approach is that in the event it established target ranges for risk premia, the ECB would have to effectively tell the market how much more risky it believes periphery debt to be compared to core debt. Is 200 basis points the correct spread between Spanish and German debt? Who knows. Worse, in the event a country like Spain's fundamentals deteriorated, the central bank would be
"...forced to either admit that the risk premia it estimated to be appropriate for that country are in fact set, not subject to revision, and thus not in anyway anchored in reality, or else reset the target range for that country's risk premia based on economic realities which could indicate to the market when and to what extent the ECB is losing confidence in that country."
Clearly this is not desirable for Spain as a reset of the target range would play havoc with yields.
In short, Mariano Rajoy can hold his breath for a 200 basis point risk premium guarantee from the ECB all he wants but it isn't going to materialize and in the mean time, all the Prime Minister will manage to accomplish is to drive up the very spread he is so concerned about keeping suppressed. As the Financial Times notes, Madrid's profoundly unrealistic economic forecasts aren't helping matters either. The IMF and the European Commission expect Spanish GDP to contract by 1.5% in 2013, three times Madrid's estimate of .5%. Expect Rajoy's "Delay and Pray" strategy to cause more pain for European (FEZ) and Spanish equities (EWP) going forward and above all, expect yields on Spanish bonds to rise markedly.