Friday, September 9, 2011

Europeans rush for the exits

The panic in Europe is palpable, and can be seen in these charts:


2-yr eurozone swap spreads have soared to almost 100 bps, nearly as high as they were at the peak of the 2008 global financial panic. U.S. swap spreads are rising in sympathy, or simply out of fear that the Eurozone mess could end up infecting U.S. markets. Spreads here are still pretty close to what would be considered normal, however.


The focal point of the panic is Greece. 2-yr Greek government yields are going vertical, as Greek government debt now sells for about 45 cents on the dollar. This implies the near-certainty of a substantial default or restructuring of Greek debt, which totals some $450 billion. This will be the biggest default/restructuring in history. Greece is being effectively shut out of the capital markets, and the Greek populace apparently could care less, preferring instead to protest even the mention of austerity measures. Something very big will have to happen to prevent this default, and it's nowhere to be seen right now.


The euro has finally slumped against the dollar, falling over 5% since August 29th, and the dollar is up almost 5% against a basket of major currencies. The dollar is now the only cheap safe haven left, since the yen and swiss franc both reached highs that were seen as untenable. The news out of the ECB today is that tightenings are off the table and an easing of policy is on the way. This is facilitating the decline of the euro and will ameliorate the pain of defaults, although it's likely to come at the cost of higher inflation down the road. Regardless, what we are seeing here is just the eventual fallout of bloated governments in Europe that have borrowed too much money and squandered it. The money was squandered—and effectively lost—long ago (see my thoughts on what really happens in a default here), and now it's a game of musical chairs to see who will be left holding the bag when the music stops as it will have to sooner or later.


The Euro Stoxx 50 index  is down by about one-third from its recent highs, and is only 17% above its March 2009 lows. Very bad news is being priced in, as the market braces for a nasty recession.


The Euro Stoxx Banks index has essentially given up all its gains since the March 2009 lows. Prices now reflect a decline of over 80% from pre-recession highs. This is a catastrophe, much worse than the 68% decline in U.S. bank stocks over the same period. The banks have paid a huge price for their mistaken belief that sovereign debt was a bullet-proof investment. The only question now is whether their capital will be wiped out and they will cease to exist. But as far as the market is concerned, we are very close to seeing that happen. Will this be the end of the world as we know it? I doubt it. Things were even worse about three years ago, yet the world has managed a decent recovery to date.

One very important thing to keep in mind: many trillions of market cap have been wiped out in the past few months, much more than the value of PIIGS debt that could be defaulted on in a worst-case scenario. As far as the market is concerned, the worst-case PIIGS scenario has already happened. Yet life goes on. There are no mass closings of factories in Europe, no mass firings, the wheels of commerce continue to turn, the traffic continues to jam around rush hour.

6 comments:

Pragmatic Investor said...

Funny I thought you said the damage for a Greek default has been done and priced in. The market doesn't seem to agree.

Dr William J McKibbin said...

Greece, followed by Portugal, Spain, Italy, California, New York, and Rhode Island...

Christian S. Herzeca, Esq. said...

OT, today's selling is at least partly attributable to trimming before a 9/11 weekend anniversary in which a credible al-quaeda threat has been discovered. if all is clear monday, the market will likely be biased up, subject of course to the screw ups from europe

Scott Grannis said...

Christian: good point

Benjamin said...

The market may be reacting to uncertainly caused by large private-equity funds such as Long-Term Capital Management.

Who knows who has leveraged 100-to-1, what young traders sitting by a computer screen has placed centi-billion bets--that he cannot back up?

I hate to say regulation--but if an AIG or Long-Term Capital Management can melt down at any time.....

William said...

Watching the ups and downs of markets the past few years is like watching some alternative economic system on adrenaline played out on a computer screen. The movements in the equity and bond markets are so exaggerated, so amplified compared to the reality of the situations.

Too many computer algorithms, too many obscure derivatives interacting at the speed of light.