Europe is on the brink of something very big

Euro zone bond markets have come completely unhinged this morning. Spanish 10-year yields have hit the highest level for the year at 6.5%. While Italian 10-year yields broke above 6% for the first time since late January. Meanwhile, German yields have moved to a record low of 1.44%. We are now back to levels of stress we last saw during the Italian crisis in November and December. However, this time policy space has narrowed considerably. In short, Europe has reached the critical breaking point.

The euro zone crisis story is now moving on numerous fronts simultaneously.

1. Greek euro zone exit: The talk of a Grexit has reached a fever pitch as the Greeks have been unable to cobble together a coalition government to implement agreed to austerity measures. New elections are slated for June, but the prospect for a resolution is no brighter after these elections as the anti-austerity parties are likely to win. As I outlined in Monday, no political party in Greece is talking about leaving the euro zone but the reality is the Greeks may be cut off if they don’t hold to their austerity pledges, leaving the government without funding. That is a situation that makes a euro zone departure all but inevitable.
2. Greek bank run: To make matters worse, there is a run on Greek banks that has been building for some time. The Financial Times reports that Greek banks have lost 5 billion euros of deposits since May 6. Meanwhile, the Wall Street Journal reports that Greek depositors withdrew 700 million from Greek banks on Monday alone. As I wrote on Monday, Greek banks could be cut off by the ECB if the Greek government reneges on its austerity pledges and defaults as a result of the Troika withdrawing aid. That would cause the Greek banking system to collapse and capital controls, heavy government control and even martial law would be the next step for Greece. At that point, the Greek government would be issuing IOUs in lieu of payment and the whole economy would grind to a halt as the banking system becomes nationalised and credit plunges. At this point, unless the EU aids Greece, leaving the euro, repudiating debt and depreciating the value of the currency would be attractive.
3. Spanish bond spike: The increase in Spanish bond yields tells us that Spain is on the verge of an existential crisis. We have reached a point where either the ECB intervenes or yields will go through the roof and the Spanish debt market will collapse, sending the entire Spanish economy and banking system into freefall. Because Spain is an economy of an order of magnitude larger than Greece, I expect some sort of intervention in the coming days and months. I have been saying the intervention will be a bank recapitalisation that at once helps the fragile Spanish banking system and the government by avoiding contingent liabilities. But there are also the ECB and the EFSF/ESM bailout funds which intervene on behalf of the sovereign.
4. Italian bonds are next: To add insult to injury, the Italians are also seeing a massive spike in yields. That means the problem is not just with Spain. So a Spanish-centric solution simply won’t work. Any remedy has to address both Italy and Spain (as well as Portugal and Ireland). Could the ECB offer explicit backstops as I predicted would eventually happen this year? Maybe, but it is too early to say because policy makers have not revealed a preference yet beyond using ESM/EFSF money for bank recaps in Spain.

Needless to say, this situation is very fluid. However, judging from the previous episodes of crisis in the euro zone, the flare up in bond markets will not end until we get a policy response and intervention.

I want to point out Willem Buiter’s call in January was that "we will certainly have a panic stage before the debt crisis is resolved". He was right on the money. So there’s a good reason that Willem Buiter is now talking about helicopter drops and massive liquidity. We are on the brink of something very big.