The endgame in European sovereign debt markets is fast approaching.  Now that the Christmas and New Year break is over and the kids have gone back to school, market participants are fully focused on driving Portugal into a bailout loan from the EU/IMF before a battle royale is waged over Spain.  At the end of last week Portuguese 10-year bond yields rose above 7% and it seems merely a matter of time before a bond buyers’ strike drives Portugal down the same road as Greece and Ireland.  There is no point in politicians blaming evil speculators, hedge funds or even the Man from Del Monte – the simple fact is that if you run a large budget deficit and need to borrow money then you are beholden to your creditors and the interest rates they wish to charge.

The coming battle over Spain will be the endgame.  It is hard to envision much more of 2011 passing by before the market participants test the resolve of Germany and the ECB over Spain – it is simply too big and too obvious a question to fester unanswered for long.  If Spain is forced to ask the EU/IMF for a bailout loan then there are real questions to be asked about the solvency of many large Eurozone banks which hold huge quantities of peripheral debt (which they have marked at par on the assumption these loans will be repaid and not restructured or defaulted upon).

So Germany and the ECB will be forced to draw a line in the sand when Spanish government bond yields begin to rise sharply.  The European Commission’s proposed plan to impose haircuts on government and/or bank bondholders will simply result in investors demanding very high coupons indeed to accept the risk of lending money to borrowers who may not pay them back fully.  This risk is similar to credit card risk – Visa and Mastercard know from history that a certain percentage of their (unsecured) borrowers will not pay them back and as a result they charge a high interest rate (circa 15%) and remain profitable businesses.  There is a price for every type of risk but it is doubtful that peripheral countries will be able to afford the yields asked of them by their bond investors.  Hence the EC plan to impose haircuts will backfire.

My own view is that Spain will avoid a bailout loan BUT ONLY AFTER A SEVERE MARKET WOBBLE.  The markets will test the resolve of Germany and the ECB and Spanish bond yields will be driven to very high levels before Germany and the ECB are forced into real action (and not just papering over the cracks as they have with Greece and Ireland thus far).  There is no point wasting column inches speculating about the precise form of the German/ECB/EU action but in the end it comes down to a political choice – does Angela Merkel/Germany want the Euro (and eurozone banks – including German banks) to fall apart or not?

The equity market’s reaction to the battle to be waged in the Spanish government bond market will probably provide the buying opportunity of 2011.  Markets have now had a very strong rally off their March 2009 lows and are back at levels last seen in August 2008 (the month before Lehman went bankrupt).  Sensible long-term investors have had plenty of time & opportunity to take some profits and raise cash.  They would be wise to hold onto this cash, watch the coming battle royale from the sidelines and be ready to re-invest their cash when the buying opportunity presents itself.