Wednesday, October 5, 2011

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.


elegantstroke said...


Nice graphs. Very interesting correlation between Euro bank stocks and T-yields.

You say US stock market is less-affected? I assume you mean the general equities market. Because the bank/financial stocks even in the US are taking a beating. Do they also correlate well with the yields?

Is the market pricing in a worse 2008?

puffer said...

I'm wondering what a chart of 10 yr yields vs. the Chinese stock market would look like. While the media obsesses about Europe, I'm thinking the bigger issue is slowing in China and a bursting of the property bubble there which is just now beginning to materialize. I believe China consumes some 40% of global copper production.... copper can't roll over like that without some serious issues in China. The real shoe getting ready to drop?

Scott Grannis said...

Re China and the 10-yr: The relationship is not nearly as tight. All stock markets have been moving down over the past year, sort of, but best correlation so far is between Eurozone banks and the 10-yr. Year to date, the correlation between Chinese stocks and the 10-yr is only 0.67.

Dr William J McKibbin said...

A Greek default would be relatively easy for the US to endure -- the problem is that Greece comes with Portugal, Spain, and Italy -- the US cannot deal with that much default -- bondholders need to lose money and not the public -- my biggest worry is that the US Federal Reserve will get dragged into the Euro crisis via "secret" loans to Europe that will remain undisclosed for the next couple of years -- the Fed did "secret" loans in 2008, and I have no doubt that the Fed is capable of the same actions today -- more at:

Scott Grannis said...

Re US bank stocks: They are down big, of course, but only down 70% from their 2007 highs. And yes, they are highly correlated with Euro bank stocks.

Benjamin said...

Why the ECB is fighting inflation now is is very good question.

Greece, if anything needs to debase their currency--but they cannot, as they are tied to Euro.

A robust recovery accompanied by moderate inflation would be a tonic for many ills.

Ed R said...

"[Since 2007] Banks' shareholders have suffered huge losses, effectively giving up a tremendous amount of their wealth to subsidize bloated bureaucracies . . . "

Were bureaucracies less bloated in 2007 then they are now?? If not, perhaps you should come up with a better reason why European bank stocks have declined so much in the past few years.

I will give you a big hint of the correct reason: the initials are E C B.