The Spanish economy is in really bad shape. Unemployment is at around 20%, with unemployment among young people close to 50%. Foreign investments have practically come to a halt. Some regions of the country (Spain is a federation whose regions enjoy varying degrees of autonomy) are at the brink of bankruptcy. And the financial sector is in such bad shape that it has its own bail-out plan, to the tune of €80bn.
To keep afloat (i.e. pay interest and due principal on current outstanding bonds and finance its operations) and try to jump-start the economy, the Spanish government must raise money by issuing debt. The problem is that Spain is perceived as such a risky lender that borrowers require a very high risk premium to compensate them for holding Spanish debt.
As a general rule of thumb, bond prices move inversely to their yield. A bond’s yield incorporates the risk of the lender and therefore, as risk premium increases, the yield does too, in a linear fashion. With higher yields, the price of newly-issued bonds is lower and monthly payments higher. The European Central Bank (ECB) announced a few weeks ago that it will commence a program to buy sovereign bonds in the open market (Outright Monetary Transactions, or OMT). The ECB’s demand for bonds will cause their prices to go up and their yields to come down. With lower yields, raising new debt is less costly for the member states who participate in the program (whose debt the ECB will purchase).
That’s the carrot. Now for the stick. the ECB’s philosophy is that it will not get involved in the market and help a member state that is not willing to help itself. ECB’s assistance comes with “strict conditionality”, which means that a member state that will ask for assistance will have to show commitment to structural reform and budgetary cuts. In most distressed countries, the public sector is inflated and transfer payments constitute a disproportionate portion of the budget.
Spanish Problems Abound
Spain is in a bind. On one hand, it really needs the money; while on the other hand, getting that money involves a lot of pain for citizens and politicians alike. Lately there have been demonstrations and even riots around the proposed austerity measures. For an outsider it may be difficult to understand how locals disagree with measures that were put in place to save their economy. However, the personal hit that many will have to take is painful and to some it will have a real effect on their standard of living. Anger is fertile ground for civil unrest, which is never good for business.
Another unique problem to Spain is the separatist sentiments in some regions. The two main regions that aspire to independence are the Basque Country and Catalonia. Budget cuts will likely include cuts to the funding that regions get from the central government. This will only make independent aspirations grow, as at the same time taxes paid to the central government will not be cut.
The decision whether to apply for OMT aid is in the hands of the Spanish leadership. The problem is that these leaders are politicians and politicians always think of the next election. This may cause hesitance and delay in the decision and keep markets unsure regarding the decision and its timing.
The two important dates to keep in mind on that score are October 21 and 18. On October 21st, there are regional elections in Galicia and in Basque Country. Results may reveal to what degree unrest influences the sentiment of separatism. Spanish politicians will watch these elections closely and may take their cue from the results.
On October 18th the EU Summit could mark another hurdle date for Spain. The feeling on the Street is that Spain is expected to make its request in time for the summit and failing to do so may increase the chances of no OMT altogether, causing more headaches for Spanish policy makers.
What We Expect to Happen:
We expect Spain to make an official request in time for the summit. The government published a new budget this week that included many reforms (and as a result thousands took to the streets in protest), a strong signal for the ECB that Spain is serious about turning around the course of its economy and its deficit.
Trade:
If (or when) Spain will apply for OMT in its short-term debt, it will be a very positive event for the EUR. Besides being a step on the way to help Spain recover from the crisis, it’s a signal to other countries and to the market that the ECB is serious about its policies.
After an initial jump, we think it’ll take another two months for the EUR/USD to reach a level of about 1.35.
In short – we expect Spain to apply for OMT in 2-3 weeks’ time and for the EUR/USD to reach 1.35 as a result within three months.
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