The continued volatility in European bond markets is not surprising. Many of us predicted that the euro was doomed as soon as members of the euro zone pushed their public debt above 100% of GDP. Now their behavior is coming home to roost as markets are sending bond yields ever higher.
In the past year Italy's 2 year government bond yield has gone from 2.7% to 4.9%, at one point touching a high of 7.5% in early December. Spain's two year yields have gone from 3.4% to 3.7%, at one point touching 5.9%, also in early December.
Rising yields on government bonds are a symptom of the root problem. The root problem for these countries in the euro zone whose interest rates are rising is too much debt. The markets are clearly starting to doubt whether some countries in Europe will ever pay back all of their debt. In fact, it has become very clear that at least one country, Greece, and perhaps several others will not pay back what they owe in full. With government Debt/GDP at 131% and a deficit as a % of GDP of 15%, Greece simply cannot stop the bleeding unless it slashes public programs and salaries, sending them into a near-guaranteed depression.
Greek two year government yields now stand at a whopping 134%. This is a clear sign that investors do not believe that Greece can ever pay back everything it owes. Italy and Spain, with exploding debts and deficits as well, were headed for the same fate, but other countries in the euro zone and the European Central Bank (ECB) intervened in a massive way. The ECB said that they were going to "actively implement" a bond buying program to relieve some of the pressure on Italy, Spain, and others.
It is this intervention that stopped the skyrocketing yields of Italy and Spain, but many feel that this is simply a temporary halt of the inevitable. The Washington DC based Carnegie Institute estimates it would take $1.4 trillion to prevent Italy from collapse and $800 billion to shore up Spain. Unless the ECB is allowed to print money to help member countries pay off their debt, it appears that both Italy and Spain will eventually meet the same fate as Greece.
Before going into the notion of the ECB printing money, let's take a look at the dizzying array of bailouts and ideas that euro zone members have come up with over the past year to help arrest the disintegration of their currency. Countries that are in the euro zone, and actually use the currency, have now resorted to asking European Union (EU) members such as England, which has its own currency, to join in the bailouts. However, England does not have as much incentive to help as they will not be as impacted by the euro currency falling apart as those in the euro zone itself.
The first major intervention was the bailout of Greece, which in hindsight has not worked. In May, 2010 the EU and the International Monetary Fund (IMF) lent Greece 110 billion euros in return for Greece promising more budget cuts. By January of 2011, all three rating agencies had cut Greece's credit rating to "junk". In April, 2011 Greece reported that it had overshot its deficit target by 10%, further sending its bond yields upward. By June Greece's credit rating was the worst in the entire world at "CCC".
Now that it's clear Greece will default, other members of the EU have admitted that Greece will need further bailouts. In fact, a new $130 billion (107 billion euros) bailout plan is ready to go. But the other euro zone members are insisting that Greek bondholders first take a 50% reduction in the principal value of their bonds.
Let's take a step back and look at why the euro currency zone experiment has been such a disaster. In 1999 the euro was formally introduced as a new currency. Sixteen countries gave up their own currencies and monetary policies to join this massive experiment where sovereign nations with different cultures, taxes, interest rates, and overall fiscal policies would be linked through one currency and one central bank. The only way it could work was if these countries adhered to the strict criteria of the Maastricht Treaty. This treaty stipulated that member states must have a budget deficit less than 3% of their GDP, a debt ratio of less than 60% of GDP, low inflation, and interest rates close to the European Union average.
Although the Maastricht Treaty was supposed to keep debt levels in check, several countries found ways around this restriction by either manipulating their reported debt levels or by simply ignoring the rules of the treaty altogether.
So countries on the euro promised to keep their budget deficits and debt in check. They broke that promise, ran up their debt, and now the entire EU is scrambling to patch it all back together. And what is their latest idea to keep things going as if nothing is wrong? They want more promises that countries in the euro zone will not run up their debt and will limit spending! If they do this and cede part of their sovereignty on tax laws and government spending to a new EU governing body, they will have access to a new 1 trillion euro bailout fund.
The new fiscal compact being pushed through will limit nations to having budget deficits of 3% of GDP yet again. Interestingly, 12 of the 17 EU members currently already exceed that limit, including the two largest economies in the European Union, Germany and France.
So what happens if all of these bailouts fail? What if countries inside of the EU begin revolting and refuse to give any more money to the countries which are in danger of defaulting? Basically there are two answers to this: 1) There will be massive defaults in the euro zone region and the euro will very likely fail quickly, with most if not all countries going back to their own currency or 2) The ECB will finally cave and begin printing money and buying government bonds in earnest in order to "save the system."
If as an investor you believe #2 will happen, you will want to be invested in gold (GLD) (SGOL). Gold skyrocketed in 2010 and 2011 mainly because our own central bank, the Federal Reserve, began printing billions of dollars (about $700 billion to be exact) in order to buy treasury bonds and keep interest rates low. Much of the market expected not only the Fed to continue printing, but for the ECB to begin as well. When that didn't occur, the price of gold fell by nearly 20% in the past three months.
So what to do if #1 occurs and there are massive defaults in the EU while the euro fails completely? One thing is for sure, don't have any money in euros. There is also the real danger of capital controls in countries whose banking systems are close to failing. There has already been talk of Greece clamping down on withdrawals from its banks. Incredibly, the Greek banking system saw a decline in deposits of nearly 30% in the past year alone.
It is difficult to predict the future, especially when you mix politics with economics. If we just had to look at the economics of the situation, the picture is quite clear: The euro currency is a massive failure and should be leading to defaults by multiple countries in the euro zone. But leaders in Europe do want to see the currency fail on their watch. They also don't want the banking system to crumble, which would certainly send the entire EU area into a crippling recession or worse. So expect the patchwork of bailouts and agreements to continue, at least until there is no country in the EU that investors trust. In other words, if the strongest and largest economy in Europe, Germany, sees its interest rates start increasing like Italy's and Spain's have, the game is over.