Busch: European Debt Crisis Surges

Today (Tuesday), Spain’s CDS is at 425, the 10yr yield is 6.25 percent, and spread to German 10yr is 384. Today, Italy’s CDS is 365, the 10yr yield is 6.10 percent and spread to German 10yr is 368. Two debt crisis indicators are flashing bright red.

  • Major Sovereign Credit-Default Swaps Now

When a country has its CDS above 400 and its 10 yr debt yield above 7 percent, these are seen as possible points of no return for a country. The CDS is seen as a leading indicator as investors/speculators buy insurance to protect against declining financial conditions.

The 10yr yield is seen as a coincident indicator that reflects investors’ unwillingness to own the sovereign bonds at their current price. When yields go up, the cost of funding a country’s debt increases. This creates the conditions for a downward debt spiral by which a country is effectively priced out of the global capital markets.

Yesterday on CNBC’s Strategy Session, we talked about how this situation is reaching an acute stage as we have moved from the periphery to the core of Europe in this debt spiral. Here are the points I used for reference:

  • Moody’s Investors Service put Spain’s Aa2 rating on review for a possible cut on July 29, citing "funding pressures." That followed a similar step for Italy on June 17.
  • This has helped create a negative debt spiral where rising rates create funding pressures that further exacerbate finances and create the conditions for downgrades.
  • Last week, Italy paid an average yield of 5.77 percent to sell 10- year debt on July 28, the most since January 2000. The yield on three-month Spanish bills sold two days earlier rose to 1.899 percent, the most since December 2008.
  • Moody's cited higher funding costs for Spain, including debt levels and access to financing, as driving reasons for why they may downgrade.
  • The concern is sovereigns will be required to pay higher yields as they sell bonds and bills, leading to a cumulative increase in their debt-servicing costs that wipes out the benefits of austerity measures endured to face down the bond markets.
  • Italy, the region’s biggest bond market, will have the second-highest debt level as a percentage of gross domestic product this year, according to a May 13 European Commission forecast. At 120 percent, it will trail only Greece’s 158 percent. Ireland’s debt will be at 112 percent of GDP, Portugal’s will be at 102 percent and Belgium’s will be 97 percent. Spain’s 68.1 percent level will be less than France and Germany, though its budget deficit, at 9.2 percent last year, trailed only Greece and Ireland.

(Source: Bloomberg, BMO)

Tomorrow, we have Italy’s PM Berlusconi address parliament and we have Economics Minister Tremonti call for a meeting of the Financial Stability Committee to address the crisis. Another indicator of the crisis, Spanish PM Zapatero postponed his vacation. Seriously. When the Italians and Spanish are staying home in August to deal with an economic crisis, the situation must be critical.

The European debt crisis is now entering the final end game stage with country’s that are “too big to fail and too big to bail” straining the ability of the union to hold together. This drives the risk-off trades higher; it forces the CHF to new all-time highs against the EUR and pushes gold to all time highs against theUS dollar. Given the recent downgrades to forecasts for Friday’s US employment data, these trades will be pushed further.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.