Monday, July 11, 2011

ECB debt contagion fears continue to rise

This chart helps to put the European debt crisis—which is focused on the debt of Portugal, Ireland, Italy, Greece and Spain—into perspective, since the yield on 2-yr government bonds is a good proxy for the market's guess as to the likelihood and magnitude of default. The real risk of default is concentrated in Greece, Portugal, and Ireland.

An investor today can choose between buying Greek bonds that are highly likely to default in some fashion, or he can buy rock-solid German bonds. An efficient market would leave the investor indifferent to the choice. Assuming that Greek bonds will lose 40% of their value in a restructuring tomorrow, then buying them today at a yield of 31% would produce a total return comparable to what could be had by buying a 2-yr German bond today. Here's the math: 0.6 * (1.31)^2 = 1.03, which is slightly more than the 2.53% total expected return on German 20-yr bonds. So one could argue that Greek bonds are priced to an almost certain and immediate default (or "haircut") of 40%. The same math suggests that Portuguese and Irish bonds, with yields of around 17%, are priced to an almost certain and immediate default of about 25%. (There are other ways of calculating the likelihood of default, but this is the simplest.)

Although the rise in yields on 2-yr Spanish and Italian debt is making headlines today, they are still far from likely to default, since their yields are only a few percentage points higher than comparable German yields. If there is a risk of "contagion" from a Greek default, the market is saying that it will most likely be limited to Portugal and Ireland.

I would emphasize that a significant default or restructuring of the bonds of Greece, Portugal and Ireland has in effect already been priced in by the market. Greek 2-yr bonds are currently trading at about 66 cents on the dollar, and Irish 2-yr bonds are trading at about 82 cents on the dollar. The market has known for months that big losses are inevitable, and losses have been taken by the holders of those bonds. The only unknown at this point is the exact amount of the eventual losses. If they are more than 40% in the case of Greek bonds, then there is more pain to come; if they are less than 40%, then that will be good news.

As the above chart of 2-yr swap spreads suggests, the level of systemic risk (using 2-yr swap spreads as a proxy for systemic risk) is still quite low in the U.S., and in Europe it is no more elevated today than it was when the ECB sovereign debt crisis first erupted in May of last year. And as the top chart reminds us, the likelihood of default was much lower last year than it is now. This looks consistent with the following conclusion: a significant default or restructuring of the debt of Greece, Portugal and Ireland is highly likely, but the risk of further contagion is likely to be low. Moreover, the risk that European sovereign debt defaults will prove destabilizing to the Eurozone economy is only moderate, while the risk that all this will have a significant or deleterious impact on the U.S. is very low. I suspect the headlines and the pundits may be exaggerating the dimensions of the problem.


Benjamin Cole said...

Side question: Argentina has boomed since it defaulted. Can Greece and Portugal do the same?

Public Library said...

So nothing to worry about.

Three countries are going to default, yields in Italy are heading towards the debt cliff at the same time Italy is supposed to bailout the other countries via the ECB mechanism. When Italy goes, so goes Spain but the real kicker is when the Chinese debt tsunami reaches shore.

The global finance game is in love with debt and sucking everything in the universe towards the center of the black hole.

TradingStrategyLetter - Weekly Summary said...

If Italy goes it will be nasty. No place to hide. Lt's hope it just the speculators driving the market in the short run.

Benjamin Cole said...

Falling long term interest rates, falling stock prices, falling forex prices, falling TIPS spreads, and if we had real time data on real estate, falling commercial RE prices. How does the Fed plan to react?

TradingStrategyLetter - Weekly Summary said...

Print baby print!

brodero said...

Why in all this discussion is there
no inclusion of the relative savings rates in the various countries ( esp. Italy)???

Benjamin Cole said...


Because we have global capital markets. Capital is cheap and abundant. Will be for generations. All polcymakers need to adjust to this new reality.

Even so, governments need to run balanced budgets (save perhaps for capital outlays).

brodero said...

3 items should be included in
sovereign discussions...Debt to GDP,Debt Service to GDP and Annual Savings to GDP

Benjamin Cole said...


From your lips to Bernanke's ears.

I fear we are doing a Japan. We have deficit spending, but no serious monetary stimulus. Ergo, the deficit spending is neutralized.

I prefer balanced budgets, and the pedal to the metal on monetary stimulus.

If ever a central bank places primacy on fighting inflation, even during a weak economy, you can be sure that economy will be suffocated.

See Japan.

Now is not the time to worry about inflation.

Jay Norman Davis said...

Scott, I believe the Gov't is leading us to socialism and they know it and are comfortable with it. They see what is happening in Europe and are indifferent to it. I suggest you read a column by John Kass in last Fridays Chicago Tribune comparing Greece today and a future US.

Jay Davis

McKibbinUSA said...

Greece is in default now, and Spain and Portugal are close behind -- a California default also appears imminent -- investors should draw a picture of a post-default world and compare it to today's world in order to evaluate how best to proceed -- stick with dividend and rent paying equities for now, but start buying into US Treasuries as yields rise past 10% -- the inevitable is inbound...

Benjamin Cole said...

OT But Interesting--

From Bloomberg--

Mary Daly holds up two charts containing 33 bars that all point down. They show eight industries getting hit equally hard after the 18-month recession ended in June 2009, suggesting that much of the past two years’ high unemployment is broad-based and should dissipate as the economy improves.
Daly is among researchers throughout the Federal Reserve system -- from San Francisco to Philadelphia and the board in Washington -- who are scouring data, examining models and gleaning anecdotes to determine why the jobless rate has remained stuck around 9 percent or more since April 2009. Most are reaching the conclusion that any long-term, structural shifts in the labor market aren’t significant enough to keep the U.S. from returning to a pre-crisis unemployment level of 5 percent to 6 percent by about 2016.

So, it is demand. We need more demand. We need to print more money.

brodero said...

Dr. McKibbin...

"a California default also appears imminent"

124 CDS for California is hardly