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Europe Continues Its Downhill Slide

Daryl Montgomery

The Finnish finance minister has said all eurozone countries are making contingency plans in case the currency union breaks up. With debt downgrades, bond market anomalies, troubled bailouts, and austerity packages with their associated riots becoming the new EU norm, their worries are obviously justified.

Last night, Moody's downgraded Italy's government bond rating two notches from A3 to Baa2. This is just above junk status. Moreover, the outlook is negative with further downgrades possible in the near future. So what happened in the Italian government bond auction this morning? Did buyers demand higher interest rates to buy Italy's increasingly risky debt as basic economic principles would predict? No they didn't. Italy sold 3.5 billion of three-year bonds at an average yield of 4.65%, much less than the 5.3% it had to pay last month. How is this possible? Apparently Italian banks couldn't resist an urge to grossly overpay for their governments newly issued debt. The ECB was most certainly backing them up behind the scenes. If this is how Italian banks do business, can we assume that they're solvent?

There is little need to pose that question for Spanish banks. Recent data indicate that they borrowed 365 billion in June from the ECB - a record amount. This compares to 325 billion in May. These numbers indicate that Spanish banks have been closed out of the interbank lending market (a good indication of insolvency). The highly troubled Spanish banking sector, which has 3 trillion in debt on its books, will be receiving an immediate infusion of 30 billion in bailout funds from the EU and another 45 billion in November. This represents 2.5% of its total debt and that amount is supposed to fix the problem. The actual funds needed will be many times that. It is impossible to say exactly how much because the financial numbers for Spanish banks are not reliable.

Spain seems to be following Greece's descent into a self-reinforcing economic collapse. This week Prime Minister Rajoy announced further budget cuts of 65 billion over the next two years. VAT was raised from 18% to 21%. Almost a quarter of the Spanish work force is unemployed, even worse than Greece's 22.5%. Spain though seems to be making a more serious effort at fiscal austerity than Greece. According to reports in the German daily Rheinische Post, the troika on its latest visit found that the Greek government failed to implement 210 of the 300 budget savings requirements it had agreed to in exchange for its bailout money.

While interest rates are pushing against unsustainable levels in Spain and Italy, they have gone to theoretically impossibly low levels in northern Europe. Negative interest rates first appeared in government debt in Denmark and the Netherlands last December. Then Germany paid negative rates on some of its short-term bonds starting in January. This week, France sold six-month Treasuries at a yield of -0.03% and two-year bonds at -0.001%. Below zero yields are a sign of severe market stress.

The euro (FXE - News) this week has traded below 1.22 to the U.S. dollar, but is slightly higher today. Investors should watch the 1.20 level. If the euro breaks and stays below this area of support, it could drop to parity with the dollar. The major central banks would intervene to prevent this though, so the ride down wouldn't be smooth.

Stock markets (VT - News) reacted bullishly in late June and early July to the news of further bailouts in the EU. Most traders didn't ask where the money would come from, nor if the plans were even legally possible. They may not be. The German constitutional court will be ruling whether or not Angela Merkel's promises to participate in the ESM (European Stability Mechanism) can go forward. Even if they rule favorably, there is little actual money committed to the ESM. More money printing (and the ECB has already done quite a bit) is the only option left to fund the various bailout schemes to save the euro. Of course, it's logically absurd that a fiat currency could be saved by producing excess amounts of it. The same is true for trying to solve a debt crisis by taking on more debt. But hope reigns eternal in the land of euro make believe.

Daryl Montgomery is Author: "Inflation Investing - A Guide for the 2010s"

Organizer, New York Investing meetup.

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