The market continued to move easily between “risk-on” and “risk-off” in July. Last month felt a lot like the past several months, i.e., it was characterized by weak economic data in the U.S. and continued evidence of a recession in Europe. As has been the case for much of the past two years, the European debt crisis continued to be the biggest driver of market volatility, particularly in the financials, with rising Spanish bond yields being the market’s primary concern.

In our June 8th post, “Crunch Time for Europe”, we discussed the market impact that the “kick the can down the road” strategy adopted by European policy makers has had. In effect, for the past two years, the pattern has been: events deteriorate and the markets (led by the financials) decline, then, after much discussion, European policy makers announce some measure to (at least temporarily) deal with that one element of the crisis, after which the markets rebound.

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This has created a challenging market environment for investors as market direction is being significantly impacted by the (often unpredictable) actions of policy makers. Crisis escalation is frustrating the bulls. Policy responses are frustrating the bears.

Two Looming Events Policy Makers Will Need to Address

And here we go again. In the next month or two, we believe there are two events that will require some action or response from policy makers. First, Spain is likely to request a bailout from the European Financial Stability Fund (EFSF), something the Spanish Prime Minister has rejected up to this point, but on which his stance appears to be softening. Second, Greece runs out of money, possibly in September.

In fact, we believe the main reason the ECB did not announce a bond-buying program in early August (thereby causing the market to sell-off), and the Federal Reserve did not go forward with QE3 (despite weakening economic data) is that they are awaiting greater clarity on these two looming risks.

So, what could happen?

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Spain Requests a Bailout, and Policy Makers Seek to Ring-Fence Spain (and Italy)

Right now, the current focus of the market is on Spanish bond yields, with emphasis on the 7% threshold. Press reports suggest the country is funded for the next few months, and appears to be privately negotiating the terms of a bailout. It is possible, and indeed likely, that this announcement is accompanied by a policy response, such as another bond buying program by the ECB of Spanish and Italian bonds (to drive down yields/borrowing costs). If Spain does not request a bailout, it is very likely its bond yields will continue to rise and the risk of default would increase meaningfully.

Greece Secures Additional Funding … or Not 

EU/IMF inspectors are expected to announce their assessment of Greek finances in September. If the Troika does what is has continually done for the past two years – i.e., give Greece more money despite zero progress – then the markets will likely rally, or at least turn its attention to other issues.

However, despite now being entirely dependent upon international lenders, Greece appears incapable of structural reform, and over the past two years has consistently tested their patience. As a result, without drastic action, the country is headed for insolvency, as its lenders will eventually cease aid altogether. This could occur in September, although it is seems unlikely that they would take this drastic step without first dealing with Spain and Italy, keeping in mind the potential for a severe negative market reaction.

We believe the only reason Greece continues to get any aid at all is that the Troika has – for now – determined it is less expensive than letting the crisis escalate. Eventually, they will make the calculation that the system is strong enough to absorb Greece moving into insolvency.

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Policy Makers Response Will Drive Market Reaction

Up to this point, European policy makers have met each stage of the crisis with a forceful response, including, but not limited to: (i) bailout funds for Greece in 2010, followed by establishing the EFSF, which was then used by Ireland (and in 2011, by Portugal); (ii) the introduction of the first ECB bond buying program (and relaxation of collateral requirements) as sovereign debt costs rose again in late 2011; and (iii) the ECB’s Long-Term Refinancing Operations (Part I, December 2011 and Part II, February 2012), as bank funding dried up.   

Now the crisis enters a new stage. Spain in experiencing a banking crisis on a scale that calls into question its ability to service its debts, while the risk of a disorderly exit of Greece from the eurozone continues to rise. As a result, the market awaits further policy responses, with the most speculated actions being the following:

1. (Another) ECB bond-buying program: With the ECB’s (theoretically) unlimited ability to buy bonds, these open market operations are a very powerful weapon policy makers have to drive down yields, particularly of Spanish and Italian bonds.

2. “Eurobonds Lite”: A policy proposal by some within Germany, called the “European Redemption Pact”. It calls for sovereign debt to be split into two categories. All debt up to 60% of GDP (i.e., consistent with the Maastricht Treaty) would remain sovereign. Debt above this amount could be transferred to a redemption fund in exchange for euro bonds that would issue debt to be retired over time (with collateral, likely gold reserves).

3. Sovereign/country bonds collateralized by gold reserves: A proposal for individual countries to collateralize all debt above 100% of GDP with gold reserves.

4. Common bank regulator, recapitalization program: Bringing the eurozone banks under one regulator, combined with some form of direct recapitalization program.

5. Federal Reserve enacts QE3: The U.S. central bank enacts quantitative easing, which would add more liquidity to the market to help support economic growth (and the markets).

Any number or combination of the above policy responses would be important offsets to the negative – and unpredictable – outcome of a gradually escalating crisis. Of course, the impact on share prices will again be measured by which is more powerful: the deterioration of the crisis, or the effectiveness of the policy response.

European Structural Reform Remains Elusive

All that said, with the exception of Greece, the GIIPS countries have made progress, especially Ireland. Nevertheless, governments continue to be reluctant to enact the most painful structural reforms, particularly those that would be “pro-growth” (such as relaxing labour laws).

Unfortunately, the seriousness of the problems emerging from the crisis continues to outpace policy progress. In absence of structural reforms, central banks printing money and direct funding/sharing risks between governments will continue to dominate policy responses. This is only buying time, and eventually fiscal reform will be needed to truly end the crisis. In the meantime, if the ECB engages in unlimited open market operations in the near-term, then the potential for a sustained “risk-on” rally rises. If not, the market could correct.

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