It seems as though the half-life of euro-zone bailouts is getting shorter. It was only a month ago that policy makers announced a bailout plan that was supposed to put an end to the region’s debt crisis once and for all. Admittedly, the details of the plan were vague and it lacked credibility, but that didn’t stop equity markets from rallying in October as rumors and speculation about the plan were leaked to the press. If euro-zone leaders were attempting to boost global equity markets by announcing a plan to make a plan weeks in the future, they succeeded. October was the best month for the S&P 500 in almost two decades. But as equity investors came to the realization that the euro-area plan was at best an incomplete solution, stocks sold off. As of Friday, the S&P 500 had given up almost 80% of its October gains and had fallen 11% from its October 27high.
With each failed bailout attempt, the crisis becomes more serious. The core of the euro area is now losing the confidence of investors. Government bond yields in France and Belgium are rising to troublesome levels, and last week a German bond auction failed. What started out as a debt problem in Greece has morphed into an existential crisis of the euro. Euro-area policy makers are now back to square one. They need to announce yet another bailout plan to save the common currency.
Financial markets see the European Central Bank (ECB) as the only credible solution, but Germany is vehemently opposed to debt monetization. Just last week, German Prime Minister Angela Merkel shot down hopes for ECB intervention and joint euro-bonds, by saying that she remained “firmly convinced” that the ECB’s mandate could not be changed and that European Commission proposals for joint bond issuance were “extraordinarily inappropriate.”
So plan B has apparently been activated. What is plan B? Prop up equity markets with the promise to announce a lasting solution to the crisis at an undetermined date in the future. It worked in October; why wouldn’t it work now?
On Thursday, Merkel, French President Nicolas Sarkozy, and Italian Acting Prime Minister Mario Monti agreed to respect the independence of the ECB by not making positive or negative demands on the bank regarding the crisis. The agreement not to comment on an ECB bailout set the stage for the rumor mill to whip stock prices around. Sure enough, before Asian markets opened Sunday night, La Stampa, an Italian newspaper, ran a story that indicated the International Monetary Fund (IMF) was planning an $800-billion bailout of Italy (backed by the ECB). The story ignited a powerful rally in Asian markets that carried through to European and U.S. markets this morning.
The IMF has since denied the report, but that hasn’t stopped speculation that policy makers are planning to deliver a credible solution to the crisis. In fact, the lead story in this morning’s Wall Street Journal is “Europe’s Leaders Pursue New Pact.” The overarching theme of the article is that a more stringent fiscal pact under negotiation by euro-area policy makers may provide cover for the ECB to fire up the printing press. The article even speculates that some ECB members plan to outvote the Germans on the board who remain opposed to debt monetization.
I can’t tell you whether the rumors and speculation in the media are just another example of European policy makers crying wolf or whether the ECB is actually planning to forcibly intervene in sovereign bond markets. The last we heard, Germany was opposed to the ECB monetizing government debt. Outvoting the Germans would be a risky strategy for the ECB to pursue, but it is also true that without ECB intervention (or a fiscal union) things could spiral out of control in Europe.
It should be clear that the eventual outcome of the euro-area debt crisis remains uncertain. Investors are welcome to take today’s stock-market rally as a signal that the euro-zone debt crisis has passed, but they may be be disappointed. Equity markets have consistently gotten it wrong when it comes to this crisis. The smart money is in the bond market. An end to the euro-zone debt crisis will likely be marked by a decided tightening in euro-area sovereign bond spreads. There has been improvement in euro-area spreads this morning, but nothing that signals an end to the crisis. A defensive investment strategy remains the mandate.
Jeremy Jones, CFA
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