Wednesday, May 5, 2010
Here's how the bond market sees the action in the eurozone financial markets. Yields on 2-yr Greek government debt have spiked to 15% or so, indicating the market sees a high probability of some sort of Greek default or restructuring. Not a total default, but at least a partial default; prices on Greek government bonds range from $84 for the 2-yr, to $76 for the 10-yr, to $60 for the 30-yr. So maybe the market is priced to something like a 20-25% haircut. Meanwhile, yields on German bonds have dropped, suggesting that investors see Germany as a safe haven, and/or investors see a Greek default spilling over into weaker European growth prospects.
This next chart shows how the U.S. bond market is reacting to the distress in Europe. Bottom line: it's not a big deal. Bond yields are down a bit, but not by enough to suggest any major deterioration in U.S. growth prospects. The market for some time now has been worried that the U.S. economy won't enjoy strong growth, and distress in Europe simply reinforces those concerns.
Here's how the stock market is reacting. Equity prices aren't down much at all, but implied volatility has spiked quite a bit. That suggests the market is more worried about the uncertainty of the Greek threat than it is about the threat it poses to growth. Previous spikes in the Vix saw much greater declines in equity prices than we have seen in the current episode. Perhaps this also suggests that the market has been captured by speculative fever—hedge funds looking for the next big killing are piling on to the Greek default story and its many possible "contagions." Might the euro get killed? Might global growth be derailed? Which country is next in line to default?
The euro has lost a little over 10% of its value against the dollar since January, and the dollar is up about 10% against a basket of currencies over the same period. This suggests that those worried about the situation in Europe see the U.S. as a safe haven—a refuge against contagion in Europe and the possibility that the euro itself could be at some risk. But looking at things from a long-term perspective, the dollar is still relatively weak and the euro is still relatively strong. So pricing has not yet even remotely reached crisis proportions.
I keep thinking this is a tempest in a teapot. Even if Greece defaults or restructures its debt, that is no reason for the euro to be dissolved, or for European growth prospects to collapse. Call me an eternal optimist, but this "crisis" has a bright silver lining, since it focuses the world's attention on one of the biggest problems faced by all major economies these days: bloated government. This issue is playing big in local elections all over the country; the Tea Party owes its very existence to this issue. The bond market, by refusing to buy Greek debt, is exerting powerful discipline on the Greek government.
What is so scary about cutting government spending? The only ones who will suffer will be the government workers that have been enjoying rising salaries, supremely generous pension and retirement benefits, and job security. The private sector has been putting up with far worse for a long time. Those who fear that cutting government spending will plunge economies into recession and deflation are the ones who don't understand that government spending is not stimulative in the first place. Big and growing government only weakens economies; so it stands to reason that cutting back on government should boost economies.
Rather than fear the deflationary consequences of slashing Greek government spending and freezing government salaries, it makes much more sense to cheer the end of big government. Less government means more freedom for the private sector; less spending means smaller deficits; smaller deficits leave more money for the private sector to put to more productive use; the return of fiscal discipline is a huge boost to confidence. The benefits of fixing the problem of bloated government surely far outweigh the costs!
Posted by Scott Grannis at 12:51 PM