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Spain & Italy: Different Problem, Same Crisis

Italy's debt is bigger, but confidence is the issue for both countries

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The bond market is indicating a pronounced lack of confidence in Spain and Italy and in the European Union itself, as we can vividly see by the rising bond yields on Spanish and Italian debt. A couple points should be made about this, however.

Contrary to popular notion, the “bond market” is not an all-knowing, all-powerful collective intelligence that sifts through the economic data and prices the respective bonds accordingly. It is a collection of emotional buyers and sellers who react to each other far more than to fundamental data.

Financial theory would tell you that bond prices change to reflect changes in the underlying fundamentals. But as any good trader knows, that relationship also goes the other way. Price movements take on a life of their own and change the fundamentals. A country that could easily finance its expenses at 4% interest may find it difficult to do so at 6%. The country thus becomes “riskier” and now requires an even higher interest rate to compensate investors for the risk … which in turn makes the country riskier still. The predictive power of the market is often no more than self-fulfilling prophecy.

Let’s return to Italy. Italy was able to amass its gargantuan debts precisely because the bond market priced yields so attractively.  But what the bond market giveth, the bond market taketh away, and now Italian 10-year yields have crept up to crisis levels close to 6%. In Spain, the yield has crept above 7%.

So, how is this vicious cycle broken?

Frankly, it’s not easy. You need a “big bazooka” blast to shock the bond market into reverse. In the case of Europe, you would need either a public commitment from the European Central Bank or one of the bailout facilities to buy as many bonds on the open market as it took to lower yields to a sustainable level.

Germany has resisted this approach, rightly pointing out that doing so takes away the incentive to cut government spending. Angela Merkel seems to believe that the only way to convince the problem states of Europe to get their houses in order is to threaten them with bond market oblivion.

Unfortunately, there are limits to how far this exercise can go, and we are quickly reaching those limits. Germany needs to commit itself to stabilizing the eurozone, and it needs to do so quickly.

As bearish as this article might seem, I am actually quite bullish on select European stocks. The crisis has created some fantastic opportunities to buy Europe’s best multinational blue chips and prices we may never see again.

I trust that as dense as Europe’s leaders might seem to be at times, they do know better than to cut off their noses to spite their faces. When faced with the destruction of the Eurozone,  they will do what needs to be done.  Today, this means aggressive bond buying by the ECB and some sort of EU oversight over the national budgets of its member states.

It will happen … eventually. In the meantime, we watch and wait.

Article printed from InvestorPlace Media,

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