It seems the luck of the Irish has finally run out. Ireland, a member of the debt-troubled group dubbed PIGS (Portugal, Ireland, Greece, and Spain), is officially in the deep end of the pool. Just how deep are we talking? Try 14.4 billion EUR deep – the size of its enormous budget deficit!
With the global recovery still far from certain, it’s only natural for investors to feel concerned after seeing Ireland’s deficit grow by another 1 billion EUR in October. Its inability to rein in its debt has already caused many worrywarts to speak up. Germany, for one, has been pushing Ireland to seek help from other European countries, but Ireland will have none of that.
While Ireland insists it’s doing fine, the state of its distressed banking industry begs to differ. Talk about being headstrong! So far, Irish officials have denied that talks for aid are underway, saying they don’t need help at the moment. They believe that any concerns will be addressed on December 7 when they release their 2011 budget, which could include spending cuts and tax hikes to the tune of 6 billion EUR.
Still, it seems that investors are already anticipating a bailout.
This can be seen in the rising yield differential between Irish and German bonds. Last week, the yield spreads on 10-year bonds hit a record high 6.46% before somewhat calming down on Friday to end at 5.64%.
Remember – to entice investors to purchase a bond, sellers (the Irish government in this case) have to compensate them with additional yield on their bonds. Increasing yield spreads signal that investors are losing confidence that the country will make good on its debt.
First, as concerns over an Irish default rise, there has been a contagion effect in the sense that it raises the same fears about other countries (think PIGS). In order to calm the markets, financial leaders are urging the Irish to put aside their pride and accept financial aid.
Secondly, as yields rise, it makes funding more expensive. As concerns pile up, the Irish may even get hit with a ratings downgrade from ratings agencies, further hampering their options down the road. So while the Irish may boast that they have enough funding until June next year, there remains a big possibility they may encounter problems in finding buyers for their bonds in the future.
This may leave Ireland with no choice but to take one for the team and accept a bailout.
And how do you think the markets will react to a bailout? Recall that in May, the IMF and euro zone members agreed to a 110 billion EUR bailout package for the Greek economy. As a result, EUR/USD sank by as much as 750 pips in the week of the announcement. Cripes!
If Ireland agrees to a bailout anytime soon, then we just might see a mini-repeat of the euro price action to the news of Greece’s bailout. Why mini, you ask? Well, the bailout might have already been priced in. After trading above 1.4200 earlier this month, EUR/USD has already dropped by more than 500 pips and is now below the 1.3700 handle.
Whether or not Ireland decides to accept a bailout package, it’s important for euro zone officials to come up with a solution– and fast! Otherwise, we just might see the euro plunge to lows not seen since the pre-euro zone banks stress tests era.