Time To Worry About Europe Again?

Uh oh…more bad political news out of Europe. Portugal’s government is at risk of falling, as two key ministers resigned in protest over the EU’s mandated austerity policies. This follows a massive protest in Greece after budget cuts forced the government to shut down the bloated state broadcaster (and fire all of its employees) and the conviction and sentencing of Silvio Berlusconi on sex and abuse of power charges.

Is it time to start worrying about Europe again?

No. At least not yet.

No Big Surprise
The Portugal developments are a little worrying but not exactly unexpected. This is politics, and if the Portuguese believe they get a better deal by challenging their creditors by taking this to the brink, then that is exactly what they will do. Spain and Ireland are also negotiating a retroactive bank bailout that would shift the debts taken on to the EU’s bank bailout mechanism and off of Ireland and Spain’s governments. Negotiations are still dragging on…and I don’t expect a definitive conclusion this year.

All of that is fine and good, but surely there will come a point to panic, right?


Yield Watching
Maybe. And that's why I'm watching Spain and Italy’s 10-year bond yields.

Spanish and Italian bond yields have been trending downward for the past year. If you might recall, ECB President Mario Draghi make his now infamous “do whatever it takes” comments almost exactly a year ago, and they had the desired effect. Except for a brief blip in February, yields have been falling almost continuously.

Until now, that is. Starting in May, Italian and Spanish bond yields started to creep up again. Spain’s 10-year yield briefly popped over the psychologically important 5% mark last month while Italy’s came close.

Is that cause for concern?

Jumping The Gun
At first glance, I would say yes. But let’s keep it context. Virtually all yields everywhere in the world rose in May and June over fears that the Fed would be tapering its quantitative easing programs. But once the dust settled, it became obvious very quickly that the bond market had jumped the gun. The tapering -- if it happens -- is still 6-12 months away. And even when it does come, it is not likely to be as harsh as the bond bears fear.

That’s nice. But what does it mean for Spain and Italy and when do we panic?

What To Watch
This will be the signal for me: if yields in the U.S. and Germany continue to drift lower, but Italian and Spanish yields rise, that would be a divergence that got my attention. It wouldn’t mean that a crisis was imminent, but it would mean that the bond market had lost confidence in the euro zone again and that Draghi’s “whatever it takes” is simply not enough.

I don’t see that happening, and I am viewing any dips in the prices of European stocks as buying opportunities.

But if I’m wrong -- and Spanish and Italian yields shoot above 5% again -- it will be time to take a little risk off the table and get at least partially defensive.