Friday, October 28, 2011
Yesterday was a big day, even though the Europeans didn't do much to solve their underlying problem, which is governments that have grown too big and taken on more debt than they can service. Debt write downs and bank recapitalizations such as were announced yesterday help address the threat of bank defaults, and that in turn reduces the threat of systemic failure and an economic collapse. But they don't solve the problem. Eventually, Greece must either throttle back its government, or abandon the euro and return to the drachma, which would then mean a sizable devaluation and a significant decline in living standards for all Greeks. Either the public sector bites the bullet, or everyone does, because the market will no longer willingly lend government the money to continue its profligate ways. (The ECB may do so, of course, and the German taxpayers may also help, but that's only a stopgap measure.) And Italy, Spain, and Portugal must also adopt concrete austerity measures.
As the top chart shows, 2-yr Eurozone swap spreads haven't changed much as a result of yesterday's debt accord, which makes sense since the accord was only the equivalent of a band-aid solution. But 2-yr U.S. swap spreads are down from 37 bps two days ago to 30 bps today; that puts them firmly in "normal" territory. Conclusion: the threat of defaults and systemic disruption remains quite high in Europe (which makes sense), but the risk that problems in Europe could seriously disrupt the U.S. economy has diminished, and is relatively low. A growing U.S. economy can effectively trump the troubles emanating from the Eurozone.
One of the biggest changes to come in the wake of yesterday's Eurozone accord was a sizable drop in the Vix index, which has come down from 45 earlier this month to 25 today. It's still elevated, but it's no longer in what might be termed the panic zone. Investors are breathing easier, but they are still genuinely concerned about the outlook.
U.S. equities have rebounded almost 17% from their Oct. 3rd lows, in part because the risk of a Eurozone contagion has declined, but mostly because the economic stats have shown that the U.S. economy continues to grow, and fears of an imminent double-dip recession were overblown. The chart above is one way to see this, since weekly unemployment claims have not deteriorated and look to be trending downward (claims are inverted in the chart), and equities had been priced to a deterioration that failed to occur.
10-yr Treasury yields have rebounded from an all-time low of 1.7% to 2.3% today, which is equivalent, as the chart above suggests, to pulling back from the edge of a depressionary abyss. Yields are still extremely low by historical standards, but at least they no longer reflect a market that is braced for an imminent catastrophe—rather, a market that still worries that the U.S. may end up in a recession. However, I think it's also likely that Treasury yields are depressed because of the ongoing troubles in the Eurozone, and are behaving more like a safe-haven than as a proxy for the long-term outlook for the U.S. economy. That's how I would explain the fact that equities display a measure of strength while Treasuries are still in recession/depression territory.
Posted by Scott Grannis at 11:20 AM