Equity markets are rightfully celebrating the fact that, in the near-term, a full blown banking crisis with private sector contagion has been avoided.  But we shouldn’t get too far ahead of ourselves here.  An interesting development in response to this Euro package is the Italian bond market.  The bond vigilantes are shrugging their shoulders at this.  As you can see in the chart below, yields on the 10 year Italian bond initially fell, but have since recovered all of their lost ground since the announcement last night.  What’s going on here?  Why are the equity markets responding so favorably while the bond market barely budges? I think the message from the Italian bond market is quite clear – this is not a real solution to the Euro crisis.  Equity markets are more hyperbolic and looking at the near-term.  One is saying, “the coast is clear for now” while the other market is saying “there is much work to be done here”.

Bond vigilantes in Greece have already learned the lesson from this crisis.  The ECB’s current strategy cannot stop yields from surging in the case of worsening budgets.  If the ECB wants to control the yields on these periphery debts they need to set the rate and be a willing buyer in any size at that rate.  This would be a step towards fiscal union and unfortunately, the Germans won’t have that.  They’d rather backstop their banks, impose austerity and hope that this crisis resolves itself. Wishful thinking if you ask me and the Italian bond vigilantes seem to agree.

The Italians have made bold targets for the coming months.  It’s eerily reminiscent of the targets the Greeks have been setting for years now.  Can they grow their economy during a balance sheet recession while the government sector contracts?  The math says no and talk is cheap.  The Greek experiment confirms this.  Italian bond markets are shrugging their shoulders at this plan.  While it may be a step in the right direction, it is by no means a real fix.  The question now is how long before the bond vigilantes get impatient and force the EMU leaders into truly bold action?

Source: Bloomberg


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • VCC

    Well put, short term you can’t fight the exuberance the equity markets have shown but the problem of excessive debt throughout the western world still hasn’t really been addressed. Support completely broke down in the USD index, looks like we’re going to challenge 1330-1370 in the SPX in the coming months as well as the dollar lows. Will be interesting to see what shape Europe is in at that point.

  • Diman

    I wonder what German BOND VIGILANTES are thinking, yeild on german 10 years bonds are up more then 8% today

  • VII

    Well Said VCC- Above my target ..and above my comfort level to stay invested but I am a lover not a fighter…At 41% cash we will let the equity orgy run it’s course.

    Ive been reading everywhere….don’t fight the tape..Haaaa that the 1370 52 week tape high(-6%) or the 1557 Oct 2007(-17%) high or the 1498 2000(-15% so far)high? The S&P is up…wait for it…1.95% this year. oohhhhhh.. ahhhhh… What is inflation?

    Maybe the equity tape promoters can tell me which one they’ve been fighting since 2000.

  • VII

    How about treasuries…up 8%.

  • Ben Dover

    Draghi has promised that the ECB will continue PIIGS bond purchases. If he doesn’t sterilize these purchases by selling other ECB bonds, this would set the ECB on a collision course with the Germans who are known to oppose such purchases.

    The possibility of an EZ crackup is seeming more and more real.

  • chris

    agreed ben.

    the whole issue of the ecb buying sovereign bonds is permit under eu treaty only as a temporary measure. hence the creation of the efsf and the handoff when (if?) the efsf gets funded.

    while the ecb can print euros to buy bonds, let’s remember that this only creates matched additional assets (purchased bonds) and liabilities (printed euros), it does not create ecb capital.

    as of 12/10, the ecb had eu5B of capital supporting eu160B of assets. i can’t find a more current unaudited b/s of the ecb as it only publishes unaudited interim eurosystem b/s, integrating all of the national banks.

    but you have to assume that having bought a bunch (i have read as much as eu50B) of greek debt and staring at a current loss of eu25B which, of course, it won’t recognize, the ecb has to be a little nervous about staying in the smp buying slumping sovereigns.

    of course, the ecb can make a capital call on the eu countries, but it seems they are all tapped out at the moment.

  • chris
  • Mark Baker

    Does the ECB have any other choice but to buy bonds forever and justify it by calling it temporary?

  • Lance Paddock

    I am with you, fighting the tape has been the most successful thing I have done over the past ten years, patience has rewarded fading bullishness repeatedly.

  • sc

    Bond markets will as a minimum wait to see exactly what fiscal action the Italians and indeed Spanish will take.If they continue to balance their books like a high risk company then their yields will be commensurate with that. Fluff like promises are unlikely to carry weight given the context of the last year.Whta this might do though is kkepp those yields nailed at just below the breaking point until they have shown some effort to really delver.In other words this weeks Euro love-in might just have been enough to keep a cap inp lace without being enough to take the boot completely off their neck.Equities different ,but whilst I can see these running up here for 3 or 4 weeks I suspect Santa might be taking a break this xmas because the macro picture didn’t look any better after this week given the kind of fiscal policies this represents.Meanwhile of course now a goodly amount of money has just been given a new definition for safe haven that doesn’t include treasuies and bunds then we can expect some stream of same stupidly wandering back into the headlights of the risk bus probably just in time to be on it when it hits’ it’s next wall.

  • Johan

    Chris, the ECB has capital of €10bn, but the eurosystem (ECB +NCBs) have a capital of €80bn, and the ECB holds >200bn in profits (mainly from gold, but also ABS) in its revaluation account.
    Also, all these purchases are funded, via the 1-week term deposit facility, so it works like a big carry trade (Similar to PBOC fx interventions, but not like the Feds or BoE’s QE), and since it is essentially a hold to maturity portfolio (ECB is not taking haircut on greek bonds in 50% PSI deal), mark to market doesnt matter.
    And at the end of the day, the ECB has only expanded its balance sheet by less than 70%, compared to +250% for the Fed and BoE, so there is plenty of room.

  • Cullen Roche

    It will be interesting to see if yields are impacted by the failure of the CDS market. Will buyers be more hesitant to buy the bonds if they feel they can’t hedge? I don’t want to overstate the risk here, but I can’t imagine that this will help keep yields low…..Talk about shooting yourself in the foot.

  • goodfriend

    Not only are CDS useless but people sitting on big fat MtM on their greek CDS should maybe book a big fat 0 in their book instead.

  • Andrew P

    If the CDS market dies, that would be a good thing since the banksters have used the prospect of vast CDS payouts as a Sword of Damocles to force policymakers to bail them out. Taking advantage of the opportunity to outlaw CDS outright would be a good thing also.

    ” If the ECB wants to control the yields on these periphery debts they need to set the rate and be a willing buyer in any size at that rate. This would be a step towards fiscal union and unfortunately, the Germans won’t have that.”

    Here is the problem with the ECB setting rates – there are 17 sovereigns in the EZ. Setting the same rate for all would be patently unfair to Germany, and setting higher rates for some than Germany will cause much political screaming. The ECB is governed by one rep from each State, with a majority ruling. While they can easily throw a basket case like Greece under the bus, I don’t see how they can set a rate for Italy higher than Germany or France given the nature of the political process. I suppose they could come up with some kind of formula to set rates for each State to take discretion out of it, but how do you do that in practice? This is the real political problem of not having a central Treasury.

  • Andrew P

    ECB capital is irrelevant. They are a Central Bank. As long as they can print a Euro and the public accepts that Euro as a Euro, and you need that Euro to pay your taxes, there is no problem.

  • Calvin

    10 year Italian bond auction caused rate to go up to 6.06% today, up from under 6% from the last auction. The credit market does not believe in this “solution”.

  • Geoff

    Given that European leaders f-cked Greek bondholders by forcing them to take a 50% haircut, it is no wonder that Italian bondholders are concerned.

  • reslez

    Sovereign CDS are like sunblock that’s only effective against nuclear radiation at a distance of 10 feet from ground zero. If you’re anywhere near an applicable situation you have much, much bigger problems. They should be renamed Credit Idiocy Swaps.

    A lender is compensated for risk with interest. The very existence of widespread CDS points to an enormous gaping hole in underwriting standards.

    It’s straight out of Monty Python. Greece needs to default. The EU can’t allow it because it would trigger credit default swaps and bring on the bankpocalypse. As a workaround they come up with a 50% “voluntary” writedown explicitly designed to not trigger CDS. Yet the whole point of CDS was to insure against loss. So the CDS turn out useless for anything except blowing up the financial markets. Which is probably a coveted feature from the banks’ point of view. Sovereign CDS should be outlawed. Their only function is looting taxpayers. And taxpayers have begun to notice.

  • Coecudgeriece

    Re-twit you post: to my @doueghua twitter