After the second bailout for Greece, markets have now turned their attention to Spain and Italy, said Tedd Scott, director of global strategy at F&C.

The immediate reaction after the recent Eurozone summit was for all periphery bonds to rally strongly, but in the last week both Spanish and Italian bond yields and spreads to German bunds are trading at record highs again.

Scott said: “The second Greek bailout, therefore, has failed in its objective of reversing contagion within the Eurozone and raises the prospect that we have entered a new, and more dangerous, phase of the sovereign debt crisis. This is because Spain and Italy, individually let alone collectively, are too big for the EU to rescue. If current yields persist or rise further something has to give.”

Although Greece, Ireland and Portugal could be bailed out, Spain and Italy are too big to fail. Italy’s debt stands at €1.9 trillion, which is roughly the same as the other three countries combined.

“In recent days, as contagion has spread, Italian and Spanish 10 year bond yields have risen to over 6%, a level that is generally regarded as unsustainable by the markets. When the yields approached 7% for Greece, Ireland and Portugal bailouts were seen as inevitable and soon followed. The problem is that this is not a feasible option for either Spain or Italy as they are too big,” Scott explained.

“The situation is made more acute by the failure of the recent emergency summit to increase the resources of the bailout fund, the EFSF, from its current lending capacity of €440bn and the increased powers that it has been granted, in particular the ability to buy government bonds in the secondary market, require new laws to be drafted and ratification by all the 17 members of the Eurozone in their respective parliaments.”

Scott said the weakness in the periphery bonds is mainly due to the market’s view that the strategy adopted by the EU, ECB and IMF to alleviate the debt crisis is insufficient to prevent more serious contagion.

“The EU and the Italian government can justifiably argue that it has a relatively low annual fiscal deficit and is able to generate a primary budgetary surplus before interest payments, but this will count for little while bond yields are being driven up to levels that effectively threaten to lock Italy out of the public sector debt market. Soothing words by politicians may calm markets for a short while but the time frame for the Euro debt crisis has become increasingly compressed and action is demanded now or in the near future.”

Italy has an “inefficient and uncompetitive” economy that has barely grown for a decade. It therefore needs big structural reforms, but a severe austerity budget combined with higher borrowing costs will most likely have the same results as it has had in Greece and Portugal: rising debt levels and slower growth. Scott said: “At the current level of bond yields of over 6% the economy needs to be growing at 1.6% just to keep the deficit from growing further.”

He believes the crisis will probably get worse until it forces radical and drastic action by the EU and ECB. “The ultimate outcome of the Euro debt crisis is binary. Either it breaks up and the politicians admit the failure of the Eurozone and the single currency or the change of strategy that was signalled at the emergency summit two weeks ago is taken to its logical conclusion. This means fiscal and political union probably involving the creation of some form of Euro bond that consolidates all Eurozone debt.

“I do not believe the Eurozone will be broken up or the Euro currency abandoned as too much political capital has been invested in it. Hence, the alternative is a more drastic response firstly involving aggressive and heavy buying by the ECB and/or the EFSF. However, as we have seen with Portugal and Ireland this is unlikely to prevent the need for a more fundamental solution that will ultimately involve the creation of a fiscal and political union. What has happened in the last two weeks is another step, reluctantly taken by the EU, towards achieving it.”

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