So back to square one?

So what happens now? How quickly do we approach a rerun of the eurozone debt crisis?

The answer is not very quickly. Spain and Italy, the two economies with problems too big for the eurozone's bailout funds to handle, have used the calm after Draghi's "whatever it takes" promise to pre-fund a good portion of their debt needs for 2013.

For example, on Jan. 15, the Italian government sold 6 billion euros in 15-year bonds, roughly $8 billion. That was the first time Italy has been able to sell 15-year bonds in more than two years, itself a sign of how far confidence has climbed. And this brought total bond sales by the Italian government in 2013 to nearly 10% of its total funding need for the year. Ten percent in two weeks -- that's a very good start for a year that will be challenging -- though less so than 2012. In 2013, it's now estimated that Italy will need to sell 186 billion euros in debt, a hefty sum but substantially less than the 235 billion euros sold in 2012. The Italian Treasury has been so encouraged by bond sales this year that it plans to offer 30-year bonds -- when the time is right, according to Treasury sources. Italy hasn't been able to sell 30-year bonds in the market since September 2009.

The story in Spain is also positive, although less so than in Italy. Spain has to sell about 8% more debt in 2013 than it did in 2012 -- about 122 billion euros this year. So far, as with Italy, the Draghi promise has brought interest rates down and given Spain renewed access to the bond markets. Foreign investors who had shunned Spanish debt before Draghi's pledge have returned to buy Spanish debt. I wouldn't call foreign holdings of Spanish debt robust, but the level has rebounded from a summer low of 33.86% of total debt to 35.44% in November.

I think the good news on bond yields and bond sales from Italy and Spain -- and from Portugal and Ireland, where those countries have said they hope to return to the bond markets as early as 2013 -- pushes a return to crisis further down the road. I think optimism about European sovereign debt has enough momentum to hold until summer.

3 signals to watch for

After that, the date on which the financial markets might see a return of the crisis depends on three things:

  • First, it hinges on the strength of a new Italian government after the February elections. The goodwill that sustained even the minimal economic reforms that Mario Monti pushed through is largely gone. A weak coalition government will have a hard time convincing the European Central Bank or the International Monetary Fund that Italy's debt is under control. I don't think a weak Italian government will create an immediate negative reaction in the bond market, but it would be the start of a creeping unease.
  • Second, it depends partly on how quickly the finances of Spain's regional governments deteriorate in 2013. Already, one-third of the planned 71 billion euros ($94.6 billion) in new debt that Spain plans to issue in 2013 (the rest of next year's total consists of refinancing debt that matures) is headed to Madrid's bailout fund for regional governments. Yes, Spain's weaker banks are likely to need further bailout funding, but I think the market already understands that and that previous bailouts have put a structure in place.

Regional government debt raises much more troubling issues for the bond markets. We've already seen the beginnings of a battle over the subordination of this debt to Spanish national debt with holders of existing regional debt protesting Madrid's efforts to make this debt junior to the national debt. Regional debt has exposed the unsettled political questions about the relation of the central government to the regional governments. With Catalonia pushing for more autonomy, regional debt could be a flash point for a genuine constitutional crisis that would unnerve bond markets. I think Spain is the likely catalyst for any revival of the eurozone debt crisis.

  • Third, it will be partly determined by whether Merkel can postpone any action likely to rile German voters until after fall elections. She certainly will try. The idea of more money for Greece is extremely unpopular in Germany. So is anything that implies joint responsibility for debt. German -- and, to a lesser degree, Finnish and Dutch -- politics will severely limit what the eurozone countries can do to head off a crisis. I don't think this moves the return of the crisis closer to us in time, but it does suggest that any effect from a return to the crisis would be addressed slowly. (This is even more likely if, as now seems to be the case, the International Monetary Fund is having second thoughts about the effectiveness of austerity economics.) Negative trends could well gain momentum. In a political vacuum, even more will depend on the European Central Bank. Draghi's promise to do whatever it takes to defend the euro might get tested.

Defending the euro

This last factor is the one that most worries me, because it, unlike an actual deterioration in the budget deficits of Spain or Greece, has the potential to significantly weaken the market's faith in Draghi's promise.

I can see a political situation arising in Germany where the opposition of the German central bank, the Bundesbank, to further support for the troubled economies and banking systems of Italy and Spain and the rest of the eurozone-crisis countries threatens Draghi's ability to deliver on his promise. And I can see a political situation arising in Germany where Merkel's position is so weakened that she can't push back against the Bundesbank. She would have to behave like the "Germany first" leader that so many in Europe fear -- wrongly, I think -- she already is.

And that would change the game. If investors start to think that the European Central Bank doesn't guarantee the markets and that the solution to the crisis depends instead on European politicians, then I think we're looking at not only a replay of 2012 but also an escalation of the crisis to something that could significantly damage global financial assets.

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I'd say the odds are against that very negative outcome. But I can't, unfortunately, rule it out.

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