MacroScope

Spain will auction up to three billion euros of a mixture of debt having enjoyed sharply lower borrowing costs at a T-bill auction earlier in the week. However, with 10-year yields still perilously close to 7 percent, it’s pretty clear that the latest austerity drive by Prime Minister Mariano Rajoy – which will take 65 billion euros out of the economy by the end of 2014 – seems to have achieved little more than settling the bond market slightly.

All the efforts of the past few weeks – the bank bailout, the fresh austerity measures and the leeway on deficit targets from the euro zone – appear aimed at keeping a full Spanish sovereign bailout at bay. But it’s quite possible that all these efforts are actually hastening a full bailout rather than warding it off by driving Spain deeper into recession and cutting state revenues.  That is something the euro zone rescue funds with a maximum of 500 billion euros at their disposal, 100 billion of which is earmarked for Spain’s banks, cannot really afford.
We’ll get the final, firm details of the Spanish bank rescue on Friday.

Secondary markets prices suggest the yields on the two-, five- and seven-year bonds will all rise from the last time these maturities were sold and Spain’s advantage of having front-loaded debt issuance in the first half of the year has evaporated as looser deficit targets agreed with Brussels and Madrid’s commitment to help its debt-laden regions have added more than 20 billion euros to the amount it thought it would have to raise in 2012.

France will auction debt worth a whopping 10 billion euros or more. The difference with Spain could not be more stark. Whether France, given its debt levels and unreformed working practices, should be viewed as “core” is a matter for debate. But it is, at least for now. While Spain has to pay 7 percent to borrow over 10 years, Paris can do so at little over two percent. Germany sold two-year debt at negative yields for the first time yesterday.

 
Ultra-low borrowing costs could be hoped to boost consumption but are a disaster for savers and institutions such as pension funds, so people may have to save even more and spend less to try and avoid an old age in poverty. Ergo, the net effect could be a further drag on economic recovery. The paradox is that further central bank stimulus to ward off a global slump will drive the borrowing costs of “safe havens” yet lower, compounding the problem. So could more QE do more harm than good? That’s a question to ponder since it’s pretty much the only policy lever left to pull.

Markets were a little unnerved yesterday by concern that Germany’s top court may take a long time to rule on complaints lodged against the euro zone’s permanent bailout fund, the ESM, which was supposed to come into effect this week. Finance Minister Schaeuble urged the constitutional court to reach a speedy decision. The judges are not expected to block it but Germany’s president says he won’t sign it into law without the court’s go-ahead. A minor delay will pose no problem. A lengthier one could jolt investors.

The head of the court raised the possibility of a review taking take two to three months. That could create a dangerous vacuum though he stressed that was just one option. Schaeuble is just out again saying he hopes for a verdict before the autumn.

Bundesbank head Weidmann said even rapid ratification may not stop the crisis escalating further. With only a maximum 500 billion euros (100 billion of which is earmarked for Spain’s banks) at its disposal, the ESM looks ill-equipped to tackle the bond market head on. When the European Central Bank intervened last year to lower Italian borrowing costs it was spending 13/14 billion euros a week. And even then, it bought only temporary leeway.

Cyprus became the fifth euro zone country to seek a bailout last night though its needs – maybe up to 10 billion euros – will not put a dent in the currency bloc’s resources. We’re still waiting to see precisely how much money Spain will take for its banks of the 100 billion euros offered. Moody’s cut the ratings of 28 of 33 Spanish banks by one to four notches last night, an inevitable consequence of the sovereign downgrade earlier this month.

Markets seems to have decided that they will be disappointed by the crunch summit at the end of the week. There was a somewhat discordant meeting between the big four euro zone leaders on Friday, with Germany’s Merkel refusing to budge in key areas, but she and French President Francois Hollande have the chance to strike a more positive note when they meet bilaterally on Wednesday abnd hot off the press we have a meeting of the finance ministers of Germany, France, Italy and Spain this evening — so maybe there is a concerted effort to get on the same page.

Lael Brainard, the U.S. Treasury guru who liaises with Europe, spoke for the rest of the world when she told us in an interview that EU leaders had to put “more flesh on the bone” of their ideas to resolve the crisis.

The euro zone’s big four meet in Rome with Germany’s Angela Merkel likely to come under pressure from Italy’s Mario Monti, Spain’s Mariano Rajoy and France’s Francois Hollande to loosen her purse strings and principles.

Monti, with Hollande’s backing, has suggested using the euro zone rescue funds to buy Spanish and Italian bonds but Berlin is not keen and there are good reasons why it might not work, not least the ESM’s preferred creditor status which means that if it piled in, private investors may flee knowing they would be paid back last in the event of a default.

The Eurogroup may have skirted the same problem with regard to the Spanish banking bailout last night by deciding to start the loans via the existing EFSF, which does not have seniority, before switching to the ESM. The EFSF’s rules will persist throughout.

It’s well and truly a Spain day.
Its 10-year yields may have ducked back below the 7 percent pain threshold but Madrid’s auction of two-, three- and five-year bonds could still be tricky. It is only aiming to sell up to 2 billion euros and should manage to thanks largely to weak Spanish banks buying them up but the five-year bond is likely to command yields last seen in 1996.

After that, an independent audit of Spain’s stricken banking sector is due to be published which will give a guide as to how much of the 100 billion euros offered by the euro zone the banks need to take to be recapitalized. Madrid may then make a formal request for aid at a meeting of euro zone finance ministers later in the day. We’ve had from sources that the audit will say up to 70 billion euros is needed but Spain would be well advised to take more to try and convince markets that it has all bases covered.

The audit is expected to divide the banks into three groups: the weakest regional savings banks heavily exposed to bad property debts, a group of mid-sized banks which face temporary liquidity problems and two ‘good’ banks – BBVA and Santander – that won’t need any help.

Italy, rapidly moving centre stage after the euro zone’s failure to assuage markets with a 100 billion euros Spanish bank bailout, faces a crunch bond auction. Having paid four percent to borrow for a year yesterday, it is likely to fork out over five percent for three-year paper although the smaller than usual target of up to 4.5 billion euros means the sale should get away. It will also issue a smattering of 2019 and 202 bonds.

Technocrat prime minister Mario Monti’s honeymoon period is over with even some he would have considered allies decrying the slow pace of his reform programme. Already this week he has appealed to Italy’s fractious political parties for support in keeping the austerity show on the road.
Today, Monti hosts France’s Francois Hollande. They agree on a lot – the need for a stronger growth strategy, a banking union established sooner rather than later and a longer-term goal of euro zone bonds. Berlin, with the possible exception of the first goal, definitely does not.

Moody’s slashed Spain’s rating to just one notch above junk last night. The power of the ratings agencies to shock is significantly diminished but if Spain’s sovereign rating drops further, more of whatever non-Spanish bank private investors are left will be forced to head for the exits. Moody’s noted that the bank bailout will increase Spain’s debt burden and the dangerous of loop of damaged banks being the main buyers of Spanish government debt which is falling in value. It repeated its warning that euro zone ratings could be cut further if Sunday’s Greek election were to increase the chances of that country leaving the euro.

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.

100 billion used to be a big number. These days, it barely buys you a little time.

Euro zone finance ministers agreed on Saturday to lend Spain up to 100 billion euros ($125 billion) to shore up its ailing banks and Madrid said it would specify precisely how much it needs once independent audits report in just over a week. 

A bailout for Spain’s banks, struggling with bad debts since a property bubble burst, would make it the fourth country to seek assistance since the region’s debt crisis began, after Greece, Ireland and Portugal.

Things are on the move in Spain although nothing is set in stone yet.
Treasury minister Montoro’s call yesterday for “European mechanisms” to be involved in the recapitalization of Spain’s debt-laden banks – a reversal of Madrid’s previous insistence that it could sort its banks alone – unleashed a barrage of whispers in Europe’s corridors of powers.

Our sources say that the independent of audit of Spanish banks’ capital needs, the first phase of which is due by the end of the month, will be a key moment after which things could move quickly.

The hitch is that Madrid still doesn’t want the humiliation of asking for a bailout and Germany will not countenance the bloc’s rescue funds lending to banks direct. One possible solution floated last night –  the EFSF or ESM bailout funds could lend to Spain’s FROB bank rescue fund, which could be viewed as tantamount to lending to the state but would give the government some political cover to say it wasn’t asking for the money. This is anything but a done deal and there would still be some strings attached which could be tough for Prime Mininster Mariano Rajoy to swallow.

With Spain’s banking system looking ever more parlous and the Damoclean Sword of Greek elections hanging over the financial markets, next week is not going to be for the faint-hearted.

Stock markets have endured another volatile week, rising early on before falling sharply just before the EU summit, then rising the day after – all this when very little changed on the euro zone landscape. Increasingly, the downward moves are sharper than the upward ones and there is little prospect of things settling before the June 17 Greek elections. It seems everyone is so nervous that if they are sitting on a day of gains, they cash them in double-quick.

Page one of the crisis management manual says get all the bad news out quickly. The handling of troubled Spanish lender Bankia has been an abject failure in that respect. First, the government said it would require about 9 billion euros to shore up, a few days on they are looking at 20 billion. One proposal doing the rounds is to create one nationalized bank out of a number of failed lenders. The big question, to borrow heavily from Louis XV, is: Apres Bankia la deluge?