Tuesday, May 25, 2010
Swap spreads are an excellent indicator of systemic risk. (See my basic swaps primer for more details.) Currently, swap spreads are saying that something is very wrong in Europe, and U.S. investors are getting very worried about a possible contagion. Sharply rising swap spreads reflect a primal fear among investors that counterparty risk is on the rise: it's as if everyone were rushing for the exit at the same time, attempting to reduce their exposure to the risk that sovereign defaults turn into major bank defaults. The market is suddenly very distrustful of nearly everyone's solvency.
The Vix Index is a good indicator of the market's level of fear and uncertainty. Fear and uncertainty started rising over concerns that a Greek default could trigger other defaults that could eventually throw a wrench into the Eurozone economy. Now those fears are being fanned by the merger of four failing Spanish banks, and rising tensions in the Korean peninsula that threaten to spill over into weakness in major Asian economies. So many problems that might have unpleasant consequences, what is an investor to do? Run for the exits.
The world's appetite for risk is suddenly less. Stocks are down, commodities are down, even gold is down from its recent high. Short-term Treasury bill yields both here and in Europe are extremely low as a result (0.15%).
I don't have any particular insight into how the world's problems can be resolved. What I do know is that the surge in swap and credit spreads, coupled with the surge in implied volatility, offer a powerful financial incentive to those brave souls willing to shoulder the risk that the world as we know it comes to an end. Disaster insurance is now expensive enough that many will decide to forego it, and many will decide to sell it. Swap spreads can't rise by much more or stay this high for much longer without there being some confirmation of the market's fears, in the form of massive bankruptcies and widespread economic destruction. Implied volatility could spike higher, as it did in late 2008, but already the potential return to selling options is becoming quite tempting.
Another thought: how can the market move so suddenly from being calm to being stormy? Greek credit default swaps were just over 100 bps about six months ago, and now they are 700, even in spite of the Eurozone's willingness to socialize the costs of Greece's debt burden with a $1 trillion bailout package. 2-yr euro swap spreads were 50 bps in early April, and today they spiked to 90 bps. Have the economic and financial fundamentals so suddenly deteriorated? Or is it that the market is just not liquid enough or deep enough or smart enough to handle just a tiny increment in perceived risk? After reading and absorbing the message of "Panic," by Redleaf and Vigilante, I'm inclined to the latter explanation. The market is not nearly as efficient as we have been led to believe. And of course it doesn't help that policymakers, being fundamentally fallible, more often than not either pursue a wrong-headed course of action (e.g., banning naked short-selling), or fail to understand what the proper course of action should be (e.g., guaranteeing the solvency of the banking system).
Here's my take: Market inefficiency and misguided public policy, not a fundamental economic deterioration, are most likely the source of these wild price swings. The market is not well suited to dealing with the uncertainty that arises from sovereign blunders, so it offers outsized returns to those who are. I believe that sooner or later enough brave souls will be found to shoulder the risk; sooner or later politicians will stumble on the proper solutions—with the help of an outraged electorate; sooner or later the economic recoveries that are underway in all the nooks and crannies of the global economy will trump the pain of debt defaults. I don't see that the world is coming to an end, so I'm not going to rush for the exit.
Posted by Scott Grannis at 11:01 AM