In Order To Be Saved, Spain And Italy Must First Be Destroyed


When diseased limbs must be sacrificed to keep the body alive life support fueled by fumes of false promises can not keep the global financial system alive. ~Alexander Higgins

There has been much confusion over last week’s remarks by Mario Draghi, with the prevailing narrative being that the market first got what Draghi meant wrong (when it plunged), then right (when it soared). The confusion is further granulated by attempts to explain what was merely a desperate attempt at delaying a decision for action, which was inevitable considering the now open opposition by Buba’s Weidmann, into a formal and planned plotline: “Inverse Twist” or other such technical jargon is what we have seen floating around. The reality is that, just like all other central bankers, Draghi did what he does best: use big words and threats of action in hope it will buy him a few extra days of time. The reality is also that, just like when the LTRO was announced, the market did get it right initially, when peripheral bonds plunged, and got it wrong over the subsequent 3 months when bond prices rose, only to collapse to new lows (and in the case of Spain – record high yields as of two weeks ago). Back then, the ECB merely bought a few months time with its transitory intervention. This time it has at best bought a few days with the lack of any actual action. And yet, Draghi did leave a way out, for at least another brief respite (where unless Europe expands the available bailout machinery yet again, the respite will have an even briefer half life than that from the LTROs). The way out is simple, and in order to avoid any confusion, we will use an allegory from the movie Batman: Spain and Italy can be saved. But first they must be destroyed.

Why? Because the market may or may note have gotten the desired knee jerk response right – higher – eventually, but what it got absolutely wrong is the fact that in the new normal, attempts to front-run politicians, whose motivations are entirely different from those of the market, are always and without fail self-defeating. In other words, by sending the Spanish and Italian curve short-ends soaring (and yields tumbling), the market just made the only catalyst that would validate the kind of response to Draghi’s comment that we witnessed in a few short trading hours, meaningless.
And what is true for Spain, is true for its far bigger, and just as financially distressed cousin, Italy.

Therein lies the rub: by pushing the funding costs on the short-end far cheaper, both Rajoy and Monti are now certain to not even consider asking for a bailout – after all the market just validated their failed policies (or so they think)! To the career politician and unappointed technocrat, instead of having to ask for aid, the market’s response is one which precludes said aid request… Until, at least such time as the market realizes it was once again manipulated by politicians.

What happens then is the same rinse-repeat cycle we have grown to hate and loathe so well: the Spanish and Italian curves go bidless, in the process inverting once again, followed by the same summit/ECB announcement response with promises that both Spain and Italy will demand a bailout, sending bonds soaring, and making a bailout demand unnecessary.

Of course, this Catch 22 of confounding cause and event can continue seemingly indefinitely, although in reality it can’t. Because fundamentally what the bond market does is keep sovereigns “honest” – just as Schauble said a week ago, Spanish yields at 7% are not the end of the world – instead what they are is a signal to the country to get its spending in control in order to reduce its deficit, and fundamentally get its house in order – yes, that means getting government spending to a sustainable level and firing hundreds of thousands of workers, as well as probably raising taxes even more. It also means pain all around, but the pain is inevitable and will only be worse the longer reality is denied.

Thus all the ECB does, with every incremental attempt to manipulate the bond curve, is delay the day when the inevitable hard choices and difficult decisions have to be made. In the process, the deficit gets bigger and bigger, even as the country can still continue to fund itself at seemingly sustainable rates (very soon both Italy and Spain will be forced to keep rolling its debt every several months as anything beyond Bills will be trading at ridiculous rates, while the short-end will be anchored by fears of more brutal Draghi rhetoric). All this comes to a head eventually when the spread between reality and central bank ivory towers becomes so wide not even the most Stockholm Syndrome-addled bond “vigilantes” can continue to ignore it any longer.

Here we completely disagree – the issue is that by formally admitting failure, it means the end for the current administrations, and a career end of many politicians, for whom preserving their jobs is a matter of survival. It also means civil unrest and disobedience, as it means the ascent of the Troika (and implicitly Germany) to the highest level of government control; what it means to the local citizens is one simple thing relinquishing sovereign control to an external presence. For those who are unfamiliar with European history, the best laid plans which have as their weakest link the assumption that any proud people will willingly cede to foreign control, always are doomed to failure.

Yet this is precisely what the bond market assumed when it sent Spanish and Italian bond yields plunging in the past week.

We give what is left of the market a few more days before the delayed correctre-reaction once again establishes itself, and the push for a formal bailout leads to curve inversion all over again, only this time more jawboning will not be enough, and neither will be Draghi’s solemn invocation to “believe him.” That bridge has now been burned.

* * *

Finally it is not just the above logic that leads us to this belief. The previously mentioned Jurgen Michels from Citi lays out all the other “weakest links” in what Draghi may or may not have said.

Below we present Michels’ latest musings on why, much to the chagrin of all those who are long peripheral bonds on hope and prayer, the market’s initial selloff reaction to the Draghi statement was in fact the correct one.

And so we finally get back to the crux of the issue, and to the Deja Vu topic of just where the money to fund Europe will come from. Recall that the EFSF leverage, to get it to €1 trillion, was the sticking point of European hollow promises in September of 2011. That entire line of thinking promptly disappeared after it was made very clear that not only can such a structured vehicle ever be completed, but that there is nowhere to fund said vehicle from. In other words Europe still needs between €700 billion (just for Spain and Italy) and €1 trillion to prefund itself for two years. This is an issue that will not go away on its own if people simply close their eyes. All Europe has done now is to shift the rhetoric to one where the ECB may, potentially, if Germany ever agrees to it, pay for some of the prefunding fees, even as the final invoice still says €1 trillion give or take. So far Germany has not agreed to anything and will not until Spain and Italy admit, loud and clear to everyone, they are broke, in the process allowing Germany to slowly commence establishing sovereign oversight.

We don’t. Which together with all of the above, we contend that – yes, the market did get it right initially when it sold of. And it will get it right again. Because Draghi did not have a master plan and all he can do now is make it up on the fly, just as Europe has been doing for the past 3 years. And even if he did, what Draghi or the anti-German members of the ECB council think no longer matters: what does matter is what Germany wants. And what Germany wants, it gets, which for all those still confused is simple – to keep Europe constantly on the edge, and the EUR low. After all for the German export industry a collapsing periphery is merely leverage to preserve its viability and keep its profitability going as the trade off to the hundreds of billions in sunk costs via TARGET2, which is merely the public financing opportunity cost to preserving a Eurozone which at this point few if any realistically expect to survive. If that means extracting as much benefit which funding a lost cause, so be it.

The irony in all this is that Bankia was almost right: however, instead of handing out Spiderman towels, it should have used Batman as its “deposit-challenged” symbol. At this point he may be the only one who can possibly prevent the destruction of Europe’s Gotham – Spain, which, however, paradoxically is the only thing that will lead to its restoration.

Categories: ECONOMY

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