European markets flashed a very clear warning signal today, which has left some investors to question if the ECB-inspired honeymoon is over.
Selling of European equities accelerated into their close. The losses were broad-based, across sectors and geographies. Whilst major indexes stabilized before they shut-down, the CAC-40 in France still lost 1.4 percent, Germany’s DAX-30 gave up 1.7 percent and Italy was a stand-out, losing 3.3 percent.
“It’s nervousness about whether Spanish politicians can successfully pull-off an austerity budget tomorrow” says Michael Browne, a hedge fund manager for Martin Currie in London, admitting the sell-off has taken him by surprise.
Importantly, the trigger appears to have been Europe’s peripheral bond markets. Spanish yields have been rising since it became apparent Madrid might play fast and loose with its deficit targets tomorrow, under unprecedented domestic pressure.
But it was selling on the Italian bond market that really made headlines. Investors sold Italian banks in what some considered to be a knee-jerk reaction to losses on the country's bonds, and trading in some — like giant Unicredit — had to be suspended due to excessive moves.
“It’s not a Unicredit story,” the editor of CNBC’s local TV partner in Milan, CFN-CNBC, Andrea Cabrini tells me.
“It’s because Italian banks have made huge profits from their holdings of Italian government debt as it rallied through the first quarter. But now the bonds are selling off, the market assumes they’re suffering losses. Yes, Prime Minister Mario Monti is gridlocked on reform here with our labor unions — but it’s as much to do with contagion from Spain,” Cabrini said.
“It’s real bad timing,” adds Larry McDonald, who trades European debt for Newedge in New York. “There’s the general strike in Spain today. And whilst Madrid says it only needs 50 billion euro to recapitalize its banks, investors fear it could be 100 billion to 150 billion euro, due to the state of the Spanish property market. The more money Spain needs, the more money the bailout funds need, and there’s clearly a huge question mark over that.”
But the big takeaway from today’s action may be that Italian and Spanish sovereign debt sold off because of the fear that confidence could decisively ebb away, taking borrowing rates for either government to unsustainable levels.
For sure, the ECB’s 1 trillion euro cash injection has reduced systemic risk by allowing Europe’s banks to refinance themselves for the next three years. But skeptics repeatedly question whether — in the medium term — that liquidity can also support anything other than the short end of bond markets.
There are also however many optimists. Larry McDonald says smart money is now buying junior bank debt in Italy. And Michael Browne is praising Mario Monti for ‘brilliantly’ managing expectations for tomorrow.
By saying he’s worried about Madrid-inspired contagion hitting his own country, Browne believes the Italian Prime minister can declare victory for the entire eurozone from whatever the Spanish deliver.