Europe: Urgent or Not?

The ECB's Draghi expressed an appreciation for the urgency facing the euro area, but he seems more isolated than he did last week when Merkel and Hollande reiterated their willingness to do what was necessary.

Even though the euro fell more than a 1.5 cents from its pre-weekend high just below $1.24, Spanish bond yields have continued to retreat. The 10-year benchmark is now about 100 bp below the level seen early last week and the 2-year yield is off about 200 bp. 

The market is pricing in a resumption of the ECB sovereign bond purchases (SMP). Yet in the past purchases by the ECB did not seem to have much lasting impact as yields and spreads continued to widen after some short-term and mostly limited reaction. The decline in Spanish yields will be tested Thursday just before the ECB meeting when Spain will raise 2.4-3.7 bln euros of 2, 4, and 10 year bonds.

The decline in Spanish sovereign yields has a positive impact on Spanish banks, as they are large holders of sovereign bonds. Spanish bank share are up over 3% today, while the overall market is up less than 2%. Over the past three sessions, the Spanish equity market has rallied 13.5%.

Ironically, Draghi seems to have a greater sense of urgency than Spanish officials. Spain continues to deny that it needs a larger aid package, such as a 300 bln euro package speculated about last week. Spanish officials also have indicated that are not prepared to formally request the EFSF to buy Spanish bonds.

Recall that Draghi's plan called for ECB buying bonds in the secondary market and the EFSF buying bonds in the primary market. It is true that German officials do not seem particularly keen about it, but Spain itself is the biggest immediate obstacle. It needs to make the formal request.

One would think that the recent news would light the proverbial fire under Spanish officials. Unemployment appears to have ticked up to a new high 24.63% and the economy contracted by 0.4% in Q2 after a 0.3% contraction in Q1 and no end to the contraction in sight.

Yet if there is a single number that captures the lack of urgency on the past of Spain it is the average cost of its debt issuance this year: 3.27% vs 3.90% last year. Ironically, this supports Germany's Schaeuble's argument that a few auctions with higher yields is not an emergency for Spain.

Although officials may say that the rating agencies are wrong or irrelevant and we agree that they use only publicly available information for the sovereign ratings, we suspect that Moody's decision to put Germany, the Netherlands and Luxembourg on credit watch (but not Finland which has insisted on collateral for its participation) is indeed noteworthy. Merkel's coalition partners (CSU and FDP) opposition to additional support for the periphery can only be emboldened by Moody's decision. Merkel's own support appears to have waned, according to the latest YouGov poll.

Draghi may have tried to deliver a fait accompli to European officials by promising to deliver a game changer, but we think the market will be disappointed. We anticipate that pressure will return. Can Spanish 2-year yields really decline another 200 bp or the can the 10-year decline another 100 bp ? The return of pressure will underscore the urgency and push European officials to address the more difficult decisions in September.