The Eurozone is stuck on a path that leads to a very nasty equilibrium.  From the Financial Times:

In a day that euro-era records tumbled, Italian yields moved through 7 per cent – a level viewed as unsustainable – for the second time in a week. The Spanish premium to Germany hit 482bp, above the critical 450bp rate at which Irish and Portuguese yields spiralled out of control and forced both countries into international bail-outs. Belgium also saw its bonds’ spread over German debt reach record levels of 314bp.

The proximate cause of the sell-off appears to have been the weak GDP 3Q GDP report:

Europe’s economic expansion failed to accelerate in the third quarter as Germany and France struggle to shore up a region bracing for a recession sparked by an escalating debt crisis.

Gross domestic product increased 0.2 percent from the previous three months, when it rose at the same pace, the European Union’s statistics office in Luxembourg said in a statement today. That matched the median forecast of 39 economists surveyed by Bloomberg News. From a year-earlier, GDP increased 1.4 percent. A separate report showed that German investor confidence fell to a three-year low in November.

One would normally anticipate that as growth decelerated, bond yields would fall in expectation of monetary easing.  Not so in Europe, as slower growth fosters fear of sovereign default as deficits widen.  As is well known at this juncture, the response of policymakers will be to enact deeper austerity measures, which will in turn slow growth further.  Not what one would call a path to a good equilibrium.

For its part, the ECB continues to dabble in bond markets, although to limited effect, failing to hold Italian yields below 7%.  Market participants are convinced that the ECB will step up to the plate eventually and act as a real lender of last resort, completely backstopping sovereign debt in the Eurozone.  Monetary policymakers, however, are digging in their heels:

The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law…“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions,” Mr Weidmann argued. “I don’t see how you can build trust in a system that violates laws.”

Fiddling while Rome burns. Literally.  One has to believe expectations of a ECB backstop are warranted, otherwise there is little if any hope for the Euro.  That said, given ECB resistance to the idea, I am beginning to believe that we will need a “Lehman” event to force their hand – at which point, of course, it would already be game over for the European financial situation.

In any event, time is running short.  From Bloomberg:

The ECB mops up the liquidity created by its purchases of distressed government bonds — 183 billion euros ($251 billion) so far — to prevent them from fueling inflation and ensure it can’t be accused of financing profligate governments.

Rabobank economist Elwin de Groot estimates that there is a “natural limit” of 300 billion euros the ECB can sterilize. “If it maintained a pace of 11 billion additional purchases each week, the average amount of purchases in the period August- September, it would hit that natural limit by mid-January,” De Groot said in a note to investors today.

When the ability to sterilize evaporates, the ECB will have to choose between expanding the balance sheet or ceasing to purchase additional Italian and Spanish bonds.  In the meantime, the ECB appears to be waiting for troubled European governments to enact just the right amount of austerity to boost confidence and send private investors scrambling for European debt.  They seem to be completely ignorant that the debt-deflation dynamic in place only erodes confidence further.

Meanwhile, the Greece situation remains unresolved.  From the Athens Times:

Greece’s conservative party leader on Monday vowed to reject any toughening of austerity measures in return for a multi-billion euro bailout, signalling the new coalition government may not enjoy the kind of cross-party support demanded by lenders.

New Democracy leader Antonis Samaras said he would not vote for any new austerity measures and added that the policy mix of spending cuts and tax rises agreed with international lenders should be changed in favour of economic growth…

…Crucially, Samaras said he would not sign any letter pledging support for conditions on a 130bn euro bailout as EU Economic and Monetary Affairs Commissioner Olli Rehn has demanded.

Another game of chicken.  One of the two must back down, it is thought, else the end result is something no one wants, an immediate Greek default.  But here again is an opportunity for another Lehman moment.

And while the the European financial system remains in jeopardy, a heavily trumpeted, supposedly key piece of the firewall, remains mired in technical difficulties, as efforts to leverage up the EFSF look doomed to fail.  From Reuters:

Efforts to amplify the power of the euro zone’s rescue fund and convince markets the bloc can handle its debt crisis risk being undermined by delays, surging bond yields and limited investor interest, potentially ruining the plan altogether.

See also FT Alphaville on rising EFSF spreads.  Not exactly an auspicious beginning.

Side note – Isn’t investor participation in the EFSF inherently risky from Europe’s point of view?  What is to prevent market participants from launching a speculative attack on both the bonds of the EFSF and the bonds of trouble nations?  Indeed, it seems like the existence of a investor dependent ESFS would only enhance the power of speculative attacks.  What am I missing hear?

Any way you cut it, the end result is recession in Europe.  For Wall Street and Washington, the question remains:  Will the US decouple, gaining traction while Europe flounders?  Or will the US be caught in the downdraft?  I remain cautious on the US outlook, despite recent possitive data.  If the US suffers from Europe’s malaise, I don’t think it would be evident before next year, which means I take little solace in the near term data flow.

Bottom Line:  The European situation remains tenuous.  Indeed, I am not sure any real progress has been made in the last few months – certainly not if the bond markets are any guide.  It will continue to get worse before it gets better, and I worry that a Lehman event will be the only thing that draws in the ECB.

Update: Zero Hedge attributes the bond sell-off not to GDP weakness, but to poor auctions.

This post originally appeared at Tim Duy’s Fed Watch and is reproduced with permission.