The divergence in European credit has perhaps reached a watershed. In non-euro denominations of European debt, such as Switzerland and Denmark, government bond yields have surged further downward to record negative yields. The Swiss 2-year note, for instance, is now yielding below –0.43%. For the sake of comparison, one year ago, during what was then believed to be no small crisis, the Swiss 2-year was yielding a respectable +0.20%. The chart for the Danish 2-year follows the Swiss issue closely.
On the other side of the continent, the south side, Spanish and Italian yields are again rising quickly. The Spanish 10-year spent most of the trading day above 7.5%, an all-time high yield. In late November 2011, during some of the worst, most illiquid days before the anesthesia of the LTRO’s, the Spanish 10-year peaked at only 6.65%.
The Spanish 2-year has gone parabolic, trading at a high yield of, unbelievably, 6.74%. It closed the trading day at only6.53% (a new euro-era high yield).
Taken together, the Spanish yield curve is now exhibiting exactly the same tendencies as Portugal, Ireland and Greece did before they were effectively taken over by Brussels. While those PIIGS countries were certainly troublesome in their own right, none of them match the potential chaos of a plateau-ed Spanish yield curve.
The scale of contagion in Spanish bond prices would be unassailable by conventional monetary means. None of the half-hearted “solutions” that have been offered to date by the European political establishment have the usable funds, or plausible commitments to obtain funds, to take on a Spanish implosion equivalent to the precedence of Ireland or Portugal. And Spain is not alone in its misery.
After fading into the background in the wake of the LTRO’s, Italy has largely been second fiddle to Spain’s pain. Now that several cities and regions are threatening bailout demands, the Italian 2-year has exploded back above 4%. The 10-year spent much of the day trading near 6.5%. The Italian problem is as much a banking contagion as any other country – so many banks in Northern European “core” countries have exposure to Italy above all the other PIIGS. In particular, French banks are full of Italian subsidiaries.
Where this all might lead is another round of general illiquidity. The first salvo toward that end was fired by LCH. Margins on Spanish bonds in the 7-30 maturity range were affected. But LCH also went after Italy, perhaps making up for inaction during Italy’s recent “quiet” period. Margins on Italian debt were adjusted at almost all points on the yield curve.
Taken together, the continual flow of money out of the “periphery” and even out of the euro altogether, will eventually be answered by another round of illiquidity and rising fear. Summer time in the post-crisis period is always hot, and this year is proving to be no different. But while Portugal and Greece were the warm-ups last year, I have to wonder if the heat will rise too much this time, especially since we have finally arrived at the main event: Spain & Italy.