Spanish bond sell-off spells trouble

After six months of improving and healthy US growth rates, the last two weeks have brought some early indications that growth has moderated a bit.  Auto sales were soft, the payroll report was mediocre, and now the NFIB survey of small businesses also came in below consensus expectations.

The NFIB survey has in recent years tracked the pattern of improving growth in the broader economy well, though it has done so from a much weaker base.  And it is one of the earliest monthly surveys that provide a fairly comprehensive look at demand, employment, wages, credit conditions and inflation.  Its deterioration in March was not that large relative to the broad improvement in the last six months.  The employment measure within the NFIB weakened the most, mirroring the payrolls report which also weakened in March after several months of stronger growth which outpaced the overall economy.

Meanwhile, although it was never certain, it was always likely that the defining moment of the European debt crisis would come in the form of the battle of Spain because of the size and seriousness of their debt crisis.

When the ECB did its LTRO, we thought it likely that this battle probably wouldn’t happen for quite some time – for 6-­18 months.  However, over the past several weeks it has become clear that foreign investors have continued to liquidate their positions in Spanish government bonds in amounts which were greater than the amounts banks are buying, that the LTRO-infused bank buying is ebbing and, as a result, the government’s funding gap is not being filled.

Furthermore, as the LTRO-financed bank purchases fade, the portion of the gaps that is not filled is likely to increase.

The fragile relationship in which troubled banks support a troubled sovereign which supports both troubled autonomous regions and troubled banks appears to now be failing and there are no clear paths to either fill or shrink the gap.

While we certainly could be missing something, it appears to us that conditions in Spain are now worse than they were before the LTRO, especially now that the LTRO is behind us. That is because it appears likely that the funding gaps will force the government of Spain, the ECB and/or the EU to make extraordinary moves that they haven’t made before that will make it clear that Spain is in trouble and that the size of the problem is large relative to the resources to deal with it.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla