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Crossroads in the EU sovereign debt saga

Irish bank stock prices have already taken a massive hit amid concerns Ireland will need an EU rescue package. And there could be more downside to come. But it's not just Irish banks investors should be concerned about.

All banks with PIIGS exposure, banks in PIIGS countries with borderline capital adequacy ratios (tier 1 under 8.5% - the new Basel III requirement) and those with high loan-to-deposit ratios could find their shares sold off if the debt crisis were to worsen. Indeed, the entire European banking sector could suffer. Just take a look at the recent share price action of the Irish banks relative to some non-Irish banks that fit these criteria...

We are at an intersection before the next phase in the European sovereign debt crisis. And the favoured direction toward stability is, historically, not easily attainable.

The current crisis is clearly a result of past decisions. Decisions not to act on traditional economic warning signs - high budget deficits to GDP, high government debt-to-GDP, low productivity growth, weak growth in real savings, high unemployment and high individual debt-to-disposable income. But perhaps it was not a decision after all, it was incapacity because the individual economies had their hands tied -they could not devalue their currency as they belonged to the euro. History tells us it is very difficult (and we are not optimistic) to reverse or hinder the final outcome of this domino effect (a default or zombie economy) given the current budget deficit of these governments.

The big question determining the next phase in the crisis will be if this contagion will spill over into the broader European economy. We expect Portugal to be next in line to follow Ireland into the soup queue, but the big worry will be Spain. Today's Spanish bond auction already showed some signs of spillover effects.

The European Financial Stability Facility (also known as the EU rescue fund) is designed to absorb the shock from multiple countries. But if Spain gets into trouble then the EU and European Central Bank have a rather significant challenge on their hands. Note the bond market does not think Spain is in trouble. But also note Spanish politicians, according to the press, for fear of the contagion spreading are the most vociferous in calling for Ireland to sort their affairs out or have them sorted out.

In the meantime keep an eye on PIIGS bond spreads to German bonds. As we wrote before the weekend, the BAA rated corporate bonds to government bonds spread has risen significantly the last month. If it continues to widen, stocks would likely fall; at least this is what history tells us.

Disclosure: No positions