PIIGS yields are higher in recent weeks as budget season gets underway.
Yields may be edging permanently higher as the debate over a longer-term solution and contentious bailout rules heats up.
Whatever future rules and bailouts look like, the current $1 trillion backstop remains firmly in place and removes eurozone default risk for now.
The US news cycle slowed considerably this week—so to fill the vacuum, it seems markets landed on the chronically recurring question of eurozone sovereign debt. But the issue didn't suddenly pop back into existence. Rather, it's been bubbling up over the last few weeks.
After the eurozone sovereign bailout package was announced way back in May, PIIGS yields plummeted and the ailing euro regained ground on major currencies. The backstop was necessary and sufficient to allay fears of a eurozone default in the near term. And it should be noted—little has materially changed between then and now. The PIIGS are still backed by $1 trillion, and in fact, they are fully funded (at market) for the year. Greece remains the only country to take bailout money.
However, yields have been rising again, and folks are taking note. The proximate cause appears to be budget season focusing attention on deficit matters. Ireland's deficit is sky high on bank bailouts, and the government recently announced an unexpectedly stringent budget. Meanwhile, political quarreling over the Portuguese budget last week worried investors. The matter has since been resolved and the budget passed.
But there's likely more than budget wrangling behind rising yields. While the global market risk of a euro default is off the table for now, the debate over a longer-term solution is just now beginning. Recent proposals may be forcing PIIGS yields higher, possibly permanently. The eurozone has strict fiscal limits member countries must adhere to—but previously there was no enforcement mechanism, and countries (the PIIGS in particular) openly flouted the rules. Low yields on riskier countries' debt assumed a backstop by eurozone's richer countries, like Germany. But now there is talk of tighter fiscal surveillance—and enforcement.
Germany and France recently presented the fiscal "teeth" to an EU summit. First, suspend EU voting rights for nations who fail to follow a sustainable debt path. But also create a more permanent crisis resolution mechanism (likely in the form of bailout guarantees) and add it to the Lisbon Treaty. A failing nation could be bailed out, but unlike the current arrangement, the debt would be restructured such that private investors take a hit before bailout funds kick in. Any restructuring would first extend the debt repayment deadline, and second, if needed, would force bondholders to accept less principal in exchange for a guarantee of remaining debt. The amount of the principal "haircut" would directly affect prices, and thus yields.
Common sense alone dictates Portugal and Ireland probably shouldn't be borrowing at German rates. And should the German proposal take effect, it would likely mean yields of riskier countries at market would remain elevated—a more realistic assessment of risk than previously prevailed. But very, very key to all this—nothing has been decided, and current proposals will not affect the $1 trillion bailout plan. Markets may take note, even jump around as the debate heats up, but the risk of default by a eurozone country remains very low in the near term.