With sentiment worsening across Europe, France has lost its relative safe haven status – credit default swap spreads on French government debt were up sharply today.
The spread between French and German credit default swaps (measuring the relative probability of default) is up – yesterday this was 40 basis points, today it stands at 44 (up from just 5 basis points at the end of 2009; most of the increase is since mid-March, with a sharp acceleration recently). French bonds have become illiquid, with wide bid-ask spreads; not what is supposed to happen in a safe haven. This is going to make the French angry – watch for more market slanders from top French politicians over the weekend; you know they would just love to ban trading in something.
These solvency problems will worsen as they are allowed to fester. And if the ECB announces it will buy French bonds, investors will probably step further back and just let them buy. We are beyond the point where mere expressions of intent-to-support will lead to a private sector rally.
Investors increasingly fear that it is simply unsustainable – economically and politically – for the ECB to support the rollover of public and private debts. If investors – acting on this belief – refuse to rollover bonds, the entire policy disintegrates into uncontrolled money issue. Quantitative Easing on this basis will fail.
The ECB is going to be forced to show a deeper hand, potentially along three dimensions.
First – the euro authorities have to let the euro truly collapse, e.g., below parity with the US dollar. This reduces solvency issues across the eurozone. Ironically, by doing nothing, and bickering within Europe as Rome (and Madrid and even Paris) burn, this is one measure that Europe seems set on delivering.
Second – if the euro devaluation does not come fast enough (or does not promise enough immediate future growth), the ECB and others will push for a “Plan B” within which at least some of the weaker eurozone countries implement “voluntary” debt restructurings (of the kind more common and not necessarily so traumatic in emerging markets; see Kazakhstan) – in which they make offers to bondholders to restructure and threaten to default if they are not accepted.
This will end rollover risk among these sovereigns – particularly as the banks will be forced to follow suit. European bank regulators need to work with each major European bank to ensure it is adequately capitalized post-restructuring. This is a good time to change management/directors and look at imposing losses on at least some unsecured creditors, although the fear at such moments is always that systemic panic will set in; vulnerable financial structures induce bailouts (and future moral hazard, as President Obama can attest). The ECB will need to provide liquidity to prevent bank runs.
Third – the eurozone nations that remain without a restructuring will need G20 support to roll over their public debts while rolling over or – failing that – restructuring some private financial sector debts. This includes France.
Progress on steps 2 and 3 require consensus within Europe and determined actions with international support. This remains nearly impossible until nations face the obvious risk of national financial collapse.
We are not there yet but this is the dangerous glide path. As the bond market moves towards a buyers strike and with Europe’s leaders doing nothing – simply hoping all their problems will melt away by themselves – the path of least resistance is to spiral downward.
Posted on June 4 on the Baseline Scenario