Eurozone contagion recap

The big market moves in the past few months have been all about Europe, as I've been pointing out since early August. The above chart should make that as clear as a bell. It compares the value of Eurozone bank stocks to the yield on 10-yr Treasuries. You couldn't find a better fit between two entirely different variables if you tried. A quick summary of what's been happening: As the sovereign debt crisis has intensified, as Greek yields have soared, as PIIGS default risk has soared, Eurozone banks—who are stuffed to the gills with PIIGS debt—have been crushed. The prospect of a PIIGS default leading to a Eurozone banking collapse has electrified the world, creating huge and even unprecedented demand for the safety of Treasuries. Moreover, it's a good bet that almost $400 billion of deposits have fled Euro banks for the relative safety of U.S. banks since last June.

The market value of Eurozone bank stocks has collapsed, down almost 80% from the high of 2007. In fact, Eurozone bank stocks are now trading at the same level as 17 years ago; that's 17 years of effort wiped out in just four years, thanks to the banks' careless assumption that they could put their entire capital at risk by investing in the bonds of Greece, Portugal, Italy, Spain, and Ireland. Greece may not have defaulted yet, but the market fully expects that, and more, to happen sooner or later. Banks' shareholders have suffered huge losses, effectively giving up a tremendous amount of their wealth to subsidize bloated bureaucracies in neighboring countries. The damage has been done, and it's all over but the shouting. The only thing we don't know yet is whether this mess will end up infecting the rest of the world.

As this next chart shows, the recent weakness in Europe has already spilled over into the U.S. equity market (and the bond market, as the first chart showed). Fortunately, the damage to the U.S. to date has been mainly reflected in market psychology, and not yet in any serious deterioration in the U.S. economy. 10-yr yields have collapsed, the Vix Index has soared, and PE ratios have plunged; but there is no evidence yet that the U.S. economy has entered another recession. Everyone is bracing for what could be a catastrophe, but it's far from certain that one will occur. Meanwhile, it is at least somewhat comforting to note that U.S. stocks have held up much better than their Eurozone counterparts.