Europe Woes Ignite Selloff

Fears Spain can’t save its troubled banks sparked a selloff in Spanish government bonds Wednesday and prompted a broad decline in stock markets and the euro, leaving Europe’s common currency in its most precarious state in months.

The market slump—driven by the latest worries over the euro zone’s fourth-largest economy—underscored investors’ concerns that European policy makers don’t have the capacity to cope with the euro-zone crisis.

Every major European exchange dropped. The Greek stock market was down 3.2%, and Spain’s benchmark index lost 2.6%. In the U.S., the Dow Jones Industrial Average fell 1.3%. Asian markets slid in early Thursday trading.

The euro fell below $1.24 for the first time since June 2010.

Assets seen as havens reaped the benefits: The German bond rallied mightily and 10-year

U.S. Treasurys were at their strongest level on record, pushing yields to a historic low.

Amid the turmoil, President Barack Obama held a videoconference with German Chancellor Angela Merkel, French President François Hollande and Italian Prime Minister Mario Monti in which they discussed developments in Europe and agreed to consult closely. The White House began setting up the videoconference last week, following a meeting less than two weeks ago in the U.S. of leaders of the Group of Eight major advanced economies.

Most ominously on Wednesday, the yield on Spanish 10-year bonds—the compensation creditors demand to lend to Spain for 10 years—rose sharply to its levels of November, before the European Central Bank stepped in with €1 trillion ($1.3 trillion) of lending to banks to ease the crisis. Yields stood at 6.69% late Wednesday, according to Tradeweb.

In other words, the ECB lending to euro-zone banks has failed to turn back the treacherous flight from Spanish debt that threatens the euro zone’s future.

Spurring Wednesday’s selloff were heightened worries over how the Spanish government will recapitalize Bankia SA, BKIA.MC -8.60% a big Spanish lender packed with troubled loans.

The European Union’s executive arm Wednesday proposed a “banking union” to ease the burden that bank rescues impose on troubled countries, but Germany quickly expressed its opposition.

Such conflicting messages served as a reminder to investors that, more than two years into the crisis, there is still no sign of a comprehensive solution.

“The financial markets wonder what’s left in the arsenal,” said Bill Gross, founder and co-chief investment officer of the $1.7 trillion Pacific Investment Management Co., a unit of Allianz ALV.XE -2.35% SE, and manager of the PIMCO Total Return Fund, the world’s largest bond fund.

Even Italy, which saw a sharper improvement in confidence after the ECB’s bank-lending moves, is degrading. Italy sold €5.7 billion of government bonds amid tepid demand. In an auction of 10-year bonds Wednesday, Italy paid 6.03% interest, a higher rate than at the last auction a month ago.

The bond stampede is particularly troubling because the ECB’s big loans were policy makers’ boldest moves in more than a year. There is little evidence European nations or central bankers have another move lined up.

The market action comes against a sobering backdrop.

Greece, the euro zone’s chief problem child, is heading to critical elections June 17, and a fresh poll Wednesday showed a left-wing party, Syriza, in the lead. Syriza is critical of the harsh austerity measures imposed by the euro zone as a condition of Greece’s bailout; many in financial markets outside Greece believe a Syriza win could precipitate a standoff with the euro zone and, ultimately, a messy breakup of the currency union.

Investors are pulling out of weaker countries such as Spain and Italy, and moving into the stronger countries, in a flight of capital and bank deposits that appears inexorable. Without buyers for their government debt, countries such as Spain and Italy will eventually run out of funds. For now, ECB lending to domestic banks has given those banks cash to buy government debt. But that is showing signs of easing, too.

And, unfortunately, the ECB’s loans gave Spanish banks the money to buy Spanish government debt from foreign investors. That tightens the interdependence of the banks and their government.

The perils of that closeness were on display Wednesday.

The government’s announcement last week that it planned a €19 billion capital injection into Bankia initially heartened markets, but quickly brought questions about where Spain would get the money to do so.

Borrowing from private markets eats up demand that Spain needs for its own financing. Injecting government bonds into Bankia would bypass the need to raise cash, but those bonds aren’t much use if the bank faces liquidity problems—unless it could use them as collateral to borrow cash from the ECB.

In news late Tuesday ECB officials signaled they would oppose any attempt to fund the rescue of Bankia via the central bank’s lending facilities, according to people familiar with the situation. The ECB on Wednesday said it hasn’t been consulted by the Spanish government and “stands ready to give advice.”

Markets wilted. Bankia shares declined 8.6% Wednesday.

Spain’s Finance Minister Luis de Guindos flew to Berlin Wednesday to meet his counterpart Wolfgang Schäuble. Thursday, the country’s Deputy Prime Minister Soraya Saenz de Santamaria will meet U.S. Treasury Secretary Timothy Geithner and the International Monetary Fund’s Managing Director Christine Lagarde in Washington.

U.S. officials are trying to keep pressure on euro-zone leaders to take larger steps to calm financial markets. One of the Obama administration’s top economic officials, U.S. Treasury Undersecretary Lael Brainard, visited Spain on Wednesday and is scheduled to stop in Paris and Berlin on Thursday as part of a weeklong trip.

The euro tumbled to $1.2366 in late New York trading, its lowest level in almost two years. The currency has dropped almost 7% against the dollar this month. The Dow Jones Industrial Average fell 160.88 points to 12419.86, its biggest decline in seven weeks and putting the index on pace for its worst May since 2010.

In the bond markets, yields on Germany’s two-year debt, known as the schatz, fell to a record low of 0.002%, according to Tradeweb. Yields fall as prices rise. Ten-year U.S. Treasurys also marked a new record as the yield fell to a record low 1.627%.

In Asia early on Thursday, Tokyo shares were down 1.8%, Australian shares were off 1.2% and South Korean shares were off 1.5%.

Some say the European Central Bank will be forced into taking more action. The giant injections of liquidity—basically, bigger, longer versions of its usual functions—have been only temporary salves. The central bank’s minimal and reluctant purchases of government bonds have done little. Meantime, the broader economy continues to stumble.

“The weaker the euro-zone economy becomes, the more they run out of other tools to use,” said David Owen, chief European financial economist at Jefferies & Co. in London. Mr. Owen says one of the few things left is a big program of quantitative easing—the outright purchase of government debt—akin to what has been done by the Bank of England and the Federal Reserve.

“At some point in the third quarter, they will be doing a QE program,” he reckons.

Fundamentally, Spain’s straits—and their effects on the wider euro zone—are stiffening a long-term standoff between Germany (and its allies in the north) and much of the rest of European Union.

Wednesday, the European Commission, the EU’s executive arm, which has pushed for bolder overhauls to the bloc’s structure, proposed a “banking union” that would share costs of bank support and rescue—in theory breaking the downward dance of the likes of Bankia and Spain.

The commission pushed to allow the European Stability Mechanism, the bloc’s permanent bailout fund, which is to come into force in July, to finance bank recapitalization directly. A spokesman for German Chancellor Angela Merkel repeated Germany’s opposition.

Many analysts say Europe is at a crucial moment, where the standoff must be broken by compromise or the countries risk an eventual breakup.

“The markets are essentially telling the Germans, you need to stand behind this,” said Pawan Malik of Navigant Capital in London. “If you want the euro, it is your call.”

.
A version of this article appeared May 31, 2012, on page A1 in the U.S. edition of The Wall Street Journal, with the headline: Europe Woes Ignite Selloff.

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