How will the never-ending eurozone crisis finally end? All roads lead to the printing press...
Recently. I have said, "watch the bond market." The action in U.S. Treasury bonds makes for a good risk barometer. If bond prices rise and yields fall, that means "risk off" is back on the menu.
That is what happened this week. The yield on the 10-year note has fallen back below 3%. (When yields are falling, bond prices are rising.)
The big spike in yield came as markets soared in the final week of June. That was the burst of stock market euphoria coupled with a "problem solved" verdict for Greece and two pieces of positive manufacturing data from the U.S.
But yields have tanked again -- and bond prices round-tripped back to recent highs -- as Europe slides right back into crisis. The warm happy feelings over Greece, and the notion of "problem solved," had a life cycle on par with the adult mayfly.
A ways back in these pages, we argued that Europe is being held together with duct tape. The tape is now badly frayed and coming apart.
If you look at the cycles of crisis coming out of the eurozone, they are getting faster and tighter. More countries are getting sucked in. The breathing space between problems is getting smaller.
This week Italy took center stage, with Spain waiting in the wings. As The New York Times recently wrote (emphasis mine):
Throughout Europe's debt crisis, Italy has largely managed to steer clear of the troubles that have engulfed its profligate Mediterranean neighbors.
But the contagion that started in the euro zone's smaller countries is suddenly moving to some of its largest. As Greece teeters on the brink of a default, the game has changed: Investors are taking aim at any country suffering from a combination of high debt, slow growth and political dysfunction -- and Italy has it all, in spades.
In recent days, Italy has become Europe's next weak link after Greece, Ireland, Portugal and Spain, harmed in particular by a power struggle between Prime Minister Silvio Berlusconi and his finance minister, Giulio Tremonti. The dispute threatens to turn the euro zone's third-largest economy, after Germany and France, into one of its biggest liabilities.
As we have said before in these pages, the eurozone's sovereign debt problems are getting bigger, not smaller. Proposed solutions are either fiendishly complicated, logistically impossible, or a mix of both.
Even worse, the crisis grows as time goes by. Dialing back the clock, a small country like Greece could have been firmly dealt with a year or two ago. Honest action far earlier in the process could have cut off the contagion.
But now the gangrene has spread from the patient's big toe to infect his entire leg. Italy? Spain? These problems are too big to fix without radical surgery.
So at what point does Europe stop throwing markets into a crisis? When does the great snowball of problems finally relent?
Some observers have predicted the euro itself is on its deathbed -- that the euro currency will not last another year. This prediction is often coupled with a bullish argument, that Europe will finally be able to heal itself when the constraints of a bad currency union are gone.
Others argue that the euro will almost certainly survive no matter what... even if it survives in a different form. We could see the euro continue to exist even if a handful of countries are kicked out, or if a two-speed Europe emerges (a sort of "core euro" and "peripheral euro" or "Mediterranean euro").
In this particular case, your editor does not support as dramatic a forecast as all that. The euro currency itself need not die within a year. Not when the simpler solution of a much, much lower valuation could do the trick.
There are really only two options in Europe. Countries like Greece (and possibly Italy?) can be allowed to default, or withdraw from the euro, or both. Barring that, either the European Central Bank or the European Union can print up a hell of a lot of euros and use them to "monetize" the bad debt.
European leaders are paralyzed because both options are so bad.
Allowing default would risk a catastrophic domino chain of follow-up consequences. Not only might a number of big European banks fail (thanks to derivative exposure), depositor banks in multiple countries might experience a "run" as the public withdraws all its cash. (This happened to Northern Rock, a British bank, earlier in the financial crisis.)
Monetizing the bad debt, on the other hand, would make the Germans very, very angry. The Germans hate and fear inflation so much that the very idea practically makes their heads explode.
(This also explains why Jean Claude Trichet, the head of the ECB, is a knee-jerk raiser of interest rates even as the peripheral eurozone economies crumble all around him.)
The hope of eurozone politicians has been, "If we stall for time, economic growth will help us out of this jam." They have been pushing off the reckoning and hoping for a global recovery, or a miracle cash infusion from China, or both.
But neither of those is coming. The recovery is stalling out, not picking up speed. Meanwhile China is contributing here and there, but has its own serious problems.
This is why, most likely at some point, they will have to "monetize" the bad sovereign debt. Either the ECB or the European Union will have to buy up huge chunks of the toxic debt, paying euros for it, much as the Federal Reserve bought toxic debt with dollars after the 2008 meltdown.
This forced action could cause the euro to fall sharply and dramatically. We could see a return to $1.30 or $1.20 levels, if not lower -- at which point uncertainties surrounding the "ugly contest" with the U.S. dollar would kick in again.
Written by Justice Litle for Taipan Publishing Group. Additional valuable content can be syndicated via our News RSS feed. Republish without charge. Required: Author attribution, links back to original content or www.taipanpublishinggroup.com.