Europe’s Boat Springs another Leak

Montreal, Canada

The financial press has sprayed so much information about the Greek debt crisis that most investors have probably grown wary of the ongoing malaise. Greece will probably receive another bail-out until this phase of the cash-pile runs dry in 2012.

A Greek default seems imminent but the Europeans continue to delay the day of reckoning. Greek bonds effectively trade at busted levels or yielding 13.59% more than German ten-year bonds or bunds. And German bunds, long believed to be a safe-haven in Europe since the outbreak of the sovereign debt crisis in January 2010, are controversial because Germany is the single largest guarantor of deadbeats in the EUR periphery. That’s another story.

The next chapter of Western Europe’s financial crisis is about to unfold. And Germany can’t backstop the massive Italian bond market – easily Europe’s largest at a combined $2.3 trillion dollars and about three times bigger than Spain’s.

Italy is no Greece. It’s also not Spain. In terms of size and outstanding debt obligations, the Italian bond market is a powerhouse. If the Europeans fail to contain the leak now springing across Italian bonds then another chapter of the 18-month old debt crisis will unfold — and it’ll be ugly. The EUR belongs closer to 1.25 or 1.20 in this ongoing saga, not 1.42 to the dollar.

Credit spreads on Italian ten-year government bonds fetch 2.31% more than benchmark German bonds. That’s up from 1.60% just four weeks ago. Spanish debt, which commands a 2.84% premium over German paper, still trades at a higher risk level. But Italy is catching up quickly.

Italy has a relatively low budget deficit of 4.6% to GDP and its banking system is probably in better shape than Spain’s because more than half of Italy’s debt is financed internally, not externally. But the country has witnessed a stagnant growth cycle for years and its debt-to-GDP ratio at 119% was second only to Greece last year. The markets have pulverized Italian banks recently with stocks in Milan getting trashed last week.

I’m pretty sure the Italians and Greeks fudged their books ahead of EMU or European Monetary Union in 1999. They don’t belong in the euro-zone. At some point in the future it’s not unrealistic to see Greece, Italy, Ireland, Spain and Portugal leave the euro-zone and become part of EMU II or a secondary currency bloc that will command much higher interest rates than its core.

Deflation is rapidly spreading across the periphery, not unlike what occurred in 1992 ahead of the collapse in the European Exchange Rate Mechanism or ERM.  By September of that year, the Italians and British had enough; higher German rates suffocated their exports and they subsequently devalued and left the ERM grid.

I’m not sure how this crisis will end or when it’ll draw to a conclusion. Yet it seems reasonable to suggest that Europe’s debt crisis will drag on for years to come, benefiting gold and the Swiss franc. The European Central Bank will launch a QE program at some point.

The dollar will also catch a bid in this mess but not because it’s a safe-haven. It’s not. It’s just highly liquid and for now, able to print its way out of misery. I suspect the dollar is next. The sovereign debt crisis is spreading across Europe and the bond vigilantes will attack the United States eventually in the absence of draconian spending cuts. That won’t happen until 2013, at the earliest.


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