Macro Focus: Spanish Game Theory

Fri, SEP 21st, 2012

Recent developments from the Fed and ECB have reduced some of the near-term market tails. Regardless of the [debatable] real economic effects of such policies, their fear mitigation cred is palpable. In light of this, stocks have rallied, sovereign bond yields have dropped and the euro has strengthened.

While this likely places a central bank floor under both the economy and the markets [for now], keeping your antenna up in Europe is still important.

One potential event worth watching is Spain – and not in the traditional manner that most of us currently think of Spain [i.e. a disaster]. Rather, this risk is to the upside; as in the Spanish government officially asking euro zone partners for a bailout. This would likely send stock markets higher. We can feel it boiling under the surface of the market. However, recently, we haven’t anticipated an immediate occurrence of this event.

In the months after Spain asked for the 100B euro bank bailout [June] we increasingly believed that they would likewise soon ask for an official government bailout given the scope of the mess in their state finances, astronomical unemployment and the extraordinarily weak housing market [which is still in sharp decline]. Too, political pressure to do so was mounting. As of now, this hasn’t happened. Markets want it, Spain doesn’t. This is understandable. There’s stigma to asking for a bailout; there are strict economic conditions; there’s a loss of autonomy and national pride [a big deal in Europe]. It’s a break-in-case-of fire type situation.

But, ever since Draghi [in late-July] opined that the ECB would do“whatever necessary to save the euro, and believe me it’ll be enough” yields in the periphery have fallen and demand at Spanish auctions has held together. Then, on Sep. 6th, the ECB came out with guns a-blazin’ when they launched the OMT program. Add to this the German high-court ruling essentially giving the legal OK to the ESM [permanent bailout fund], and Dutch parliamentary elections fleshing out as pro-euro and you have a real nice win streak in Europe. Indeed, the Spanish 10-year bond yield has dropped about one-fourth, while the 2-year bond yield has been halved over this period. This has placed Spain in a position where urgently seeking aid isn’t absolutely crucial to its near-term survival.

With that background in mind, the need for the Spanish government to promptly ask for an official financial rescue had diminished, in our view. In fact, Mariano Rajoy has all but acknowledged that he sees little point in applying for assistance unless Spain’s bond yields rise significantly. Yesterday’s Spanish auction [of 10s and 3s] was yet another test of this position. And it passed [demand was good yields were lower].

As we think through the situation, it’s clear to us that precisely now is when Spain should be asking for a bailout [so long as it’s deemed inevitable, which most do]. The reason? They are currently in a better bargaining position while yields are low and the bailout is less necessary. European officials certainly would agree to help them right away. Many high-level officials have all but asked them to seek aid. The alternative is that Rajoy waits until something causes Spanish yields to creep [or shoot] back up at which point his government will be forced to go hat-in-hand. They are sure to get less favorable terms in that state. To that approach we say, “oh boy, Rajoy.”

If Spain were to set the wheels in motion for seeking aid now perhaps they could design something of a “precautionary” credit line as opposed to the Greek-style comprehensive macroeconomic survival kit administered in times of dire straits. Pursuing the former would place the appropriate financing structure is in place to draw on it if required. And the breathing room – provided by the ECB’s OMT – in negotiating this now would serve them well.

Our progressive understanding of this condition [and the corresponding game theory] has caused us to reasonably adjust upward the chance of Spain officially seeking a bailout sooner rather than later.

It’s worth noting that not a single penny of the 100B euro restructuring and recapitalization funds asked for in June has been delivered. Perhaps this is another box checked on why Rajoy may delay in asking for anything further.

Yesterday, market rumors began to swirl around Spain being in discussion with EU leaders over a possible rescue plan that could be announced soon.

There could be something to this. Or, it could be nothing. But we need to be aware.

The next event we are watching for insight into the timing [and likelihood] of both the delivery of Spanish bank funding and the possibility of an official request at the government level for aid are the September 28th Spanish bank stress tests. Additionally, a couple of key regional elections in mid-Octobter — chiefly in the Basque Country and Galicia — may provide some sway.

Markets around the world will be watching. Policymakers will be watching. We will be watching.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.