AMSTERDAM—Markets were anticipating something from policymakers last week to provide relief after truly horrible trading in May; but they were sorely disappointed.
Only a few rumors were leaked but then promptly refuted. So the European financial market was left to itself to digest a dismal Italian bond auction and horrible news out of Spain. Stocks tumbled, and are now deeply in the red for the year.
The EURO STOXX lost 4.2 percent to close at 2,068 points, down 10.7 percent for the year. The banks and Spain were hit hard, with the euro banking index down 5.1 percent whereas Spanish stocks crashed 7.3 percent to multiyear lows and are now down 29 percent year-to-date.
Credit markets were also active and Spain was the main target. The credit default swap to insure Spanish five-year bonds widened to 600 basis points (bps), or 6 percent, during the week, an all-time record. At this price, it would cost $60,000 to insure $1 million in Spanish bonds with a five-year maturity for one year. The bond yield itself, measuring underlying risk, is also rapidly approaching 7 percent, a level widely perceived as a target for intervention by the European Central Bank (ECB) and some market participants interpreted the erratic trading pattern late on Friday afternoon as a sign that the central bank was actively supporting the market.
An Italian bond auction that disappointed on both the demand and the pricing side did not help sentiments. The 10-year bond priced at a yield above 6 percent compared to 5.84 percent in April and the demand dropped to 140 percent of the volume on offer compared to 148 percent at the previous auction.
“The auction doesn’t provide any arguments to become bullish on peripherals again. We’re seeing Italy being taken hostage by the Spanish concerns. The market does not discriminate anymore, it is either ‘risk on’ or ‘risk off,’ you either buy periphery as a whole or you sell it,” commented Michael Leister, a rate strategist at DZ Bank in Frankfurt.
Banking Crisis in Spain Intensifies
Last week, the bad news came from all directions.
First, the parent company of the recently nationalized bank Bankia restated its 2011 profit of 41 million euros ($50.98 million) to a loss of 3.3 billion euros ($4.10 billion). Previously, the auditor Deloitte & Touche had refused to sign off on the accounts.
While the loss reflects the loss in value of Bankia itself, this hardly inspires confidence in the Spanish banking system, which is already suffering from massive deposit outflows, losing 31 billion euros ($38.54 billion) in April, or 1.9 percent of its total deposits.
Bankia was further mired in controversy when it became apparent that one of its financial directors would leave with a 14 million euro ($17.40 million) severance package, including pension benefits. After public outrage, he was later stripped of that prerogative by the board of directors.
To add insult to injury, Egan Jones downgraded Spain’s sovereign rating from BB- to B with a negative outlook: “Spain continues to be weakened by the government deficit of 9.6 percent (based on first-quarter results), an estimated decline in GDP of 1.7 percent (per the Economy Ministry), 24.4 percent unemployment, the IIF’s recent estimate of additional bank loan losses up to $260 billion euros, and possible depositor withdrawals.” Egan Jones often is ahead of the other big rating agencies and is gaining a wider following among market participants.
No Help From Policymakers
Based on the known numbers for the Bankia bailout, Goldman Sachs analyzed the expected capital shortfall of six other publicly listed banks and concluded that they would need to be recapitalized to the tune of 25 billion euros ($31.08 billion) in an operation similar to the U.S. TARP program. The trouble with Spain is that the fund set aside for this operation is drained of reserves and currently only has 5.3 billion euros ($6.59 billion) available.
Markets briefly rallied on the rumor that Spain might be able to write government bonds to its banks, which they could then post at the ECB in return for liquid loans to make up for the capital shortfall. That rumor was quickly refuted by the ECB as it would constitute a breach of its charter and is akin to a direct bailout by the central bank.
Another proposal to help Spanish banks was put forward by the European Commission (EC). The rescue facilities set up by the European Union could be used to stabilize Spanish banks directly “to sever the link between banks and the sovereigns, direct recapitalization by the ESM might be envisaged” said a EC press release. This idea, however, was also promptly shot down by representatives of the German government, who said that Germany would insist on honoring previous treaties, which do not allow this type of capital transfer.
Strong Policy Response Needed to Stem the Tide
Past initiatives by politicians were mostly short-lived and by and large unsuccessful, so it remains to be seen whether they can find a more permanent solution to the crisis. It seems certain that the European financial system will keep on tottering without help from politicians and central banks.
Mizuho Bank’s chief European economist Riccardo Barbieri Hermitte believes that policymakers are going to take action, but are facing a race against time. “Given the aggravation of the Spanish banking crisis and continuing uncertainty about the Greek election outcome, institutional investors and major corporations are now intensely discussing and drawing up contingency plans for the breakup of the euro,” he said in a research note.
Possible policy measures that would likely calm markets for the time being would be jointly issued government bonds, or “eurobonds,” a continent-wide deposit insurance or supra-national bank recapitalizations. A longer term solution could be fiscal and political union.
The Week Ahead
A key event for this week is the policy meeting of the ECB, which has some room to either announce a rate cut to 0.75 percent or introduce some unconventional measures to reduce market stress.
GDP will be released for the eurozone and any disappointment will add further tension as will negative trends in the German industrial production numbers, which come out on Wednesday.
France will also hold legislative elections and elect deputies for the lower house of parliament. A majority win for president François Hollande’s socialist party is widely anticipated.
