Sticking my neck out….

Guest post by Louis Copper of BGC.

If you really want to know what investors are currently thinking, then move away from looking at equities, and turn your attention to government bond markets.  These are showing quite clearly that fear is returning. Investors are fleeing for safety and demanding a high price for taking on risk.  So today Germany has sold E4.21bn of two year notes at record low yields – at an interest rate cost of just 0.14%. As Journalist Graeme would say “Wowser”.  And it comes only eight days after Switzerland sold two year notes at a record low interest rate of negative 0.251% (investors are willing to lend Switzerland more money than they will get back because they so want the safety of the Swiss government).  At the same time, borrowing costs for the troubled Eurozone countries are rising fast.  A week ago – last Wednesday – Italy sold 361 day bills at 2.84%, more than double the previous rate of 1.405% at an auction in March.  And although the Spanish debt auction yesterday is being taken positively (because it managed to sell more debt than anticipated) Spain paid a price for this – again the interest rate was around double that of the previous month.  A good test of investor’s confidence in Spain will come tomorrow with the sale of ten year bonds (the boss of the largest bond investment fund in the world, PIMCO’s Bill Gross, said that anyway Spanish bond auctions are mostly sold to Spanish banks – there are few other buyers).   However despite rising fear, we are not yet at crisis yet, with 10 year yields on Spanish and Italian debt still 1-2% below the unsustainable 7-7.5% yields of last Autumn.  So when will the next crunch come?   When will even the local banks in Italy and Spain refuse to buy their own countries debt?

Clearly the pressure is back on – as expected the LTRO was just a giant and expensive sticking plaster – the newsflow is pretty dire.  The Telegraph warns today that Italy may well have to revise down its growth forecasts from a contraction of  -0.4% to as much as -1.2% for 2012, which will result in a worse debt position.  The US Treasury’s undersecretary for International Affairs, Lael Brainard has warned that Europe must avoid a “downward spiral of austerity and recession”. Francois Hollande has reaffirmed his commitment to renegotiating the fiscal compact if elected. Even the Bank of Japan’s, Deputy Governor Nishimura said about Europe that “ Risks remain and they remain large”.  But to top it off, the Nobel Prize winning economist  Paul Krugman’s view in a piece in the New York Times “Rather than admit that they’ve been wrong, European leaders seem determined to drive their economy – and their society – off a cliff, and the whole world will pay the price.”  So dire warnings from almost every continent.

The question therefore is when and not if another real crisis happens in the markets – potentially pushing Spain into a bailout, Greece to renege on its austerity promises, Portugal into a second bailout etc.   There are plenty of possible catalysts for this – events that could spark fear and volatility.  Elections in Greece and France in the next month, the deadline for the creation of the permanent bailout fund, the ESM in July.  Disappointing news from the IMF’s spring meeting, or the G20 this weekend (although expectations are pretty low and staged photo calls and statements tend to be taken rather well by markets sucked in to the positive rhetoric).  More evidence of the damage done by the Spanish property bust to Spanish banks (although already the Bank of Spain in total demanded over E53bn of new capital to be injected into its banks).  The problem is that any of these events could be enough to swing the market’s mood, but it is difficult to predict which one.  At the moment, the market is fearing what will happen, what investors are waiting for is evidence.  And particularly important is evidence on economic growth – surveys, output data etc – the real fear is a sharp fall in GDP in Spain and Italy.  Worse than forecast output data makes a government’s debt position significantly worse because of the double whammy effect of tax falls and spending increases.  So any evidence that GDP is collapsing, is highly likely to be the catalyst for another crisis.  And for both the two too-big-to-fail, too-big-to-bail, indebted nations – Italy and Spain – there has been a change of government in the last six months whose first job has been to impose austerity.   Both Mariano Rajoy Brey and Mario Monti have inherited a debt pile which both are addressing with severe and unpopular cuts and tax rises.  As these measures bite, the recession deepens.  Given that many austerity measures are only just being implemented, it may well take some months for the full effects to show up in the economic data.  That means the second quarter of the year is when growth could slow sharply.  As data released that confirms a sharp slowdown and the markets will start feeling the fear (because of the impact slower growth has on debt).  The 2Q ends in June and so the GDP data is released in July and August.  So another crisis for our summer holidays.. yippee…