Thursday, November 10, 2011

Swap spread update


This chart updates the status of 2-yr swap spreads in the U.S. and the Eurozone. The situation is getting pretty intense in Europe, now that Italy is being put to the test. U.S. markets have finally reached the point (i.e., swap spreads above 35-40 bps) where they tell us that some market participants are starting to get worried that Eurozone troubles could spread to the U.S. The level of US spreads is still relatively tame, however, and all the recent indicators continue to suggest the U.S. economy is doing Ok, but Italy is such a big potential problem that it is hard to ignore. It wasn't too hard to shrug off a Greek default, but even the hint of an Italian default is enough to send shivers through the markets. I don't think we'll see an actual default, but when markets get like this then they can easily draw blood. Italy is going to have to do something meaningful to staunch the bleeding.

Markets in general are doing their best to send a message to countries with bloated governments: if you don't clean up your act, we are going to punish you. Markets can usually get their way, so I wouldn't be anxious to bet on an end-of-the-world-as-we-know-it scenario.

9 comments:

Bill said...

I know you don't think Europe is going to go down the tubes, but assume worst case scenario and the big guys default; how big an impact on the US and how long for the US to recover? Is it a big enough concern to get out of the market at this point?

John said...

Bill,

Events in Europe could get worse before they get better. There is a delicate dance going on. Germany needs Greece and Italy to form governments led by technocrats that can implement the austerity policies necessary to calm the bond markets. However, elections can't be put off forever. The people resent the dictation by Germany of new rules for their governments when the Euro treaties promise national fiscal autonomy. There is going to be uncertainty for awhile yet.

On an optimistic note, Italy's debt is of varying maturity and the ECB can buy enough to give the new government time to cut spending and hopefully calm the markets. The longer term problem remains whether the people will tolerate the pain.

There are many advocates of the worst case scenario. If the worst case occurs and we get a messy default, we can expect massive QE action from both the ECB and the US Fed. I would also expect virtually all other central banks around the world would be cooperating. Gold would likely spike and our markets here would probably experience considerably more volatility. I am not expecting this outcome. But it is possible.

I can't tell you what to do but I plan to do a little selling hopefully into strength over the next few weeks to raise some cash. My large cap dividend payers I will keep. These should weather a euro induced downturn...I'm not expecting dividend cuts. If the selloffs come, I'll go shopping again, just like in june/july 2010 and july-september 2011.

Good luck.

Dr William J McKibbin said...

With Italian yields above 7%, Italy will either cut spending and raise taxes (austerity) or default -- the inability of Eurozone states to "print" money rules out inflation -- however, the cuts that will be necessary will essentially mean putting 25%+ of Italians into permanent unemployment -- the question that remains to be answered is this: Will austerity measures result in civil rebellions or revolutions along the southern flank of Europe (?) -- the risk of war eventually breaking out in Europe (keep an eye on economic refugees) is increasing is on the rise...

Cabodog said...

Buying the votes of people, with their own money, only lasts as long as there is... money.

As painful as it is (and will be), glad to see this charade finally get the attention it deserves.

The USA is next if things don't change.

Bill said...

Thanks John. I guess Thatcher was right when she said that the problem with socialism is that eventually you run out of other people's money.

Benjamin said...

This is the result of bloated governments, and central banks that choose to fight inflation in a recession.

I doubt we will see recovery in jobs markets or real estate as long as the Fed targets 2 percent inflation.

The new central banker motto: "Today Japan, tomorrow the world!"

Public Library said...

Its not about bloated governments. Its about trade policy + subsidized financing of that trade policy.

Benjamin said...

Every now and then I like to be optimistic, so here goes:

The Dow is over 12k and above 12 p/e, despite a possible Euro-debacle. That is fairly resilient.

The euro is proving a major mistake; Greece and Italy cannot print money and pay down debts. For such nations, the printing press is their only friend, and they don't have it anymore. Oh sure, they should be more responsible, and dogs shouldn't chase cats.

If we can see daylight anytime for more than a year or two, I suspect Dow goes to 14k. If the Fed gets aggressive, I can see 15-15k on Dow, and a real estate recovery.

The Dow is trading at 1999 levels and real estate at roughly the same. Unit labor costs are falling in the USA. Jeez, nowhere but up--if Ben Bernanke would just get some nerve.

damien said...

Bill,


Your blog has been great and I am plagarizing your Eurozone gap stuff worst then Kudlow sometimes..:-) I think Italy noise is gonna aggravate for a few more cycles, heck Greek took 3 months and it is just still not over...

All I know right now is that the EU mood swings are fantastic for stock options juice because of the Beta. I am seeing that this slow and steady US growth will allow many to take advantage of 1950's lows and build a great capital base for their long-term portfolios. Lot of value out there if patient.

BTW, loved the El Chalten/Patagonia pics...