With the European sovereign debt crisis escalating dramatically, after Italian bond yields hit record highs on Wednesday and France’s bond spread over German bunds continues to widen, the possibility that the EU will fail to find a solution and will be forced to break up is now very real.
Nouriel Roubini, the famed NYU economist dubbed Dr. Doom for his ultra-bearish predictions, argues that without the ECB engaging in QE (drop rates down to zero and massively purchase bonds) and a strong stimulus program from Germany, the European Union will not survive.
Italian bond markets might have passed the point of no return on Wednesday, when yields on 10-year sovereigns traded around 7.5. According to High Frequency Economics, Italian bond price action erased about EUR50 billion of wealth on Wednesday. The following day, the Italian Treasury placed EUR5 billion in 1-year bonds at a rate of 6.087%, helping to materialize a clear yield curve inversion.
While it appears possible that Italy may be able to save itself, Roubini doesn’t believe so. According to the FT‘s James Mackintosh, Rome’s finances can be sustained for about a year at current, and slightly higher rates.
On the surface, the problem is investor confidence and political willingness from France, Germany, and the ECB to bail the Italians out, a move that seems more tenable now that PM Silvio Berlusconi has agreed to resign. But on a fundamental level, the problem is much deeper than it seems. Roubini thinks the problem is so bad that it will lead to a debt restructuring of Italy’s massive EUR1.9 trillion in sovereign liabilities, along with a return to Italy’s former currency. In other words, the execution of a dreaded euro break up.
The argument appears to have been that Italy, and Spain, face a problem of liquidity, unlike their battered fellow PIIGS which also face a problem of solvency. Italy does have a primary surplus and, even though unproductive, counts with a working economy. But, Roubini argues, once an illiquid but solvent country loses market credibility, and is practically pushed out of global markets by widening spreads, its debt dynamic becomes unsustainable and the country itself becomes insolvent.
Italy is indeed nearing the point where it will lose market access, as Barclays’ analysts suggest. As the France, Germany, and the ECB put pressure on Italy to get its reforms going before providing support, bond yields reach a level “which might trigger more and more capitulation selling by traditional investors in sovereign bonds. The latter could well lead to an erosion of the investor base in Italian sovereign debt,” which indeed could keep yields from ever falling to sustainable levels.
