What's the Half Life of a Bailout? About One Week...

Late on June 28, European leaders announced that they had agreed to recapitalize Spanish banks without adding more debt to the Spanish government's balance sheet. Subsequently, Spanish bonds rallied and yields fell. However, the market impact of this bailout has just run out.

Spanish 10-year benchmark bonds sold off for two straight trading days heading into Friday and continued selling off in early trade. Yields, which move inversely to bond prices, rose near the dreaded 7 percent level once again. When the 10-year bond yields of Greece, Ireland, and Portugal reached this level, they were forced to enter a full Troika bailout with harsh budgetary conditions.

Ten-year benchmark Spanish bond yields reached a high of 7.16 percent on June 18. These rising yields forced previously reluctant leaders to agree upon a direct bank bailout through joint bailout funds, including the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM). After the late June European Summit led to this new plan, Spanish 10-year bonds yields fell to a low of 6.25 percent. Since Tuesday, Spanish bonds reversed much of their post-Summit gains. Friday, Spanish 10-year yields touched 7.036 percent, before falling back below the 7 percent level.

Overnight, Spanish Industrial Production (IP) was reported as better than expected. Spanish IP contracted 6.1 percent in June. Economists' consensus expectation was for a 8.5 percent contraction in IP following May's 8.3 percent contraction. This Spanish IP beat did not evoke a rally for the country's bonds.

The recent uptick in Spanish bond yields may have been due, in part, to renewed fears of private bondholder subordination. In Greece's restructuring, the European Central Bank (ECB) and other government authorities received preferential treatment. The authorities took no losses as private bondholders suffered a haircut. Investors might be worried that the same will happen to Spanish and Italian debt.

As part of its Securities Market Program (SMP), the ECB bought bonds of different European nations, including Spain and Italy. Should these nations require a restructuring, the ECB could be forced to take losses on these bonds. The ECB could be forced to print money to recapitalize itself or sell assets and shrink its balance sheet to cover the losses. Either way, the economy could suffer: increasing the money supply is inflationary and contracting the ECB's balance sheet would likely slow European economic growth.

Spain's Ibex Index fell around 2.67 percent on Friday, led lower by financials. BBVA BBVA, one of Spain's largest banks, fell 5 percent. Spanish 10-year bonds yielded 6.95 percent as of writing, and 2-year bonds yielded 4.88 percent, up 27.6 basis points.