The most immediate potential trigger to spook investors has already begun to take its toll on peripheral sovereign bond yields: a delay by the Spanish government in requesting any official support. However, a request for official support by Spain is inevitable. Consequently any market pressure on Spain and other peripheral countries in the run up to such a request will be reversed once Spain does ask for EFSF/ESM help.
Another potential short-term trigger to spook investors is a debt restructuring and EZ exit by Greece. This could occur as early as the first half of next year if the current Greek coalition collapses and is replaced by a Syriza-led, hard bargaining coalition that goes to the brink with the troika and is too inexperienced to pull back. There is also a chance the troika will continue to keep Greece on life support until after the German elections (September 2013) and until both Spain and Italy are in partial bailout programs (Spain: any day now, Italy: probably after their election in Q2 2013). We have seen over the past year that negative developments in Greece have sent Spanish bond yields soaring, and a debt restructuring and EZ exit by Greece would have an even greater impact on investor confidence in the other peripheral countries.
Another looming potential trigger is the Italian election, to be held by the end of April 2013. The election campaign in Italy is already underway, and could cause investors to shun peripheral debt for two reasons. First, there are three fairly well-established Eurosceptic parties: Berlusconi’s People of Freedom (PdL), Beppe Grillo’s Five Star Movement and the Lega Nord. Beppe Grillo—whose party is now the third largest in Italy with around 20% support according to opinion polls—recently called for an Italian referendum on EZ membership. Even if these parties do not find their way into government, their anti-austerity, anti-bailout rhetoric will cause some investors concern. Furthermore, as the election campaign progresses, many of Italy’s main political parties are pledging to not just halt the further implementation of some of Mario Monti’s reform agenda, but to roll it back as well. This will rightfully cause investors to worry that Italy will not succeed in restructuring its economy to find sustainable growth within the EZ.
Even if the best case scenarios regarding structural reforms comes to fruition and both Spain and Italy implement them aggressively, investors might still lose confidence in the EZ crisis response. Structural reforms undermine growth in the short-term, so any OMT purchases would be happening against a backdrop of awful economic data coming out of Spain and Italy. Bond buying from the EFSF/ESM and the ECB helps to address the fiscal crisis, but does not address the balance of payments crisis or the growth crisis in the peripheral countries.
Once Spain does submit to EFSF/ESM conditionality and the ECB’s balance sheet is in play, we are likely to see a huge steepening of the yield curve. I expect the ECB will intervene in a seemingly unlimited way at the short end of the yield curve, while the EFSF/ESM will engage in primary market purchases along the rest of the yield curve. The EFSF/ESM has a very clear lending ceiling, and investors will recognize that the ceiling is too low to buy up significant amounts of debt for both Spain and Italy. Consequently they will continue to avoid longer dated paper. If a much steeper yield curve is extrapolated out into the future, it points directly towards a debt restructuring, and investors may steer clear altogether.
Furthermore, the EFSF/ESM and the ECB are now a double act. The ECB will only intervene as long as Spain (and eventually Italy) is subject to conditionality. Once the EFSF/ESM cash has all been used up, there will be no more conditionality. It is unlikely the ECB would continue to buy bonds in the absence of conditionality,
given that it has set out conditionality as a precondition for activating the OMT.How quickly could they burn through all the EFSF/ESM cash? The bailout funds can purchase up to 50% of all new debt issuance. If we assume that the EFSF/ESM buys the maximum amount of Spanish and Italian debt in each auction and credit lines are also used to cover the Spanish and Italian deficits, then the cash could run out in late 2014. This assumes that Spain does not take advantage of the fact that it will be the first country to avail of the ESM by pre-funding as much as possible.
Another potential trigger for investors to shake off any OSI euphoria is backsliding by EZ policymakers on establishing a clear road map towards a banking, political and fiscal union. The ECB’s intervention cannot singlehandedly solve this crisis, and Mario Draghi has suggested that he is trying to build a bridge for policymakers with the OMT to grant them the space to nudge the EZ towards an optimal currency area. So far, the most progress we have seen on this has been on the banking union, with policymakers agreeing at the June 28-29th EU summit to establish the ECB as the EZ-wide banking supervisor by January 1st 2013. Since then, the German government has suggested that January 1st is an overly optimistic deadline for achieving this, and deep divisions have emerged between countries on exactly which banks the ECB should supervise. This backsliding on the least controversial aspect of a banking union does not bode well for leaders agreeing steps towards not only a banking union but a political and fiscal union as well.
The ECB’s announcement of the OMT has had a very positive impact on bond yields already, without any countries going through the steps necessary to request it. Mario Draghi has shown that words continue to be the currency of central bankers. Once the OMT is actually activated, the impact on the sovereign debt markets will likely continue to be positive. Is there a state of the world in which the OMT buys policymakers time and they use that time wisely to draw a line under the EZ crisis? Sure. But I wouldn’t bet the farm on it given how many potential pitfalls there are.