Monday, October 24, 2011

Eurozone contagion fears are weakening

Since July it's been obvious that the Eurozone debt crisis was seriously impacting U.S. financial markets, creating the fear that a Eurozone financial meltdown could spread to the U.S. and ultimately trigger a global depression/recession. A brief recap of how all these things have played out is in order, especially since there are signs that the panic may be subsiding, at least in the U.S.

Eurozone swap spreads first started jumping in June, and have since reached levels that signal real panic and unquestionably high systemic and counterparty risk. U.S. swap spreads, in contrast, have risen only marginally and remain at levels that are within what might be called a normal range (2-yr swap spreads are currently 36 bps). The gap between Eurozone and U.S. swap spreads was a very good indication that while the troubles in Europe threatened to become contagious, the U.S. economy was not yet experiencing any significant deterioration.

That's been clear from a variety of high-frequency indicators, such as weekly unemployment claims. Claims have been slowly declining since June, and are down considerably from last year's highs (see first chart above), and private sector payrolls have continued to expand. The trend in claims also matches fairly closely the progress in the S&P 500, as illustrated in the second chart above.

The U.S. M2 money supply started rising significantly in June, reflecting what appears to have been a flight to safety out of Eurozone banks, which I calculate amounted to about $400 billion. But in recent weeks M2 growth has reverted to something more normal.

As the chart above shows, there has been a very tight correlation between the Eurozone stock market (orange line) and 5-yr Treasury yields. As the panic in Europe intensified, financial markets sought the safety of short-term Treasuries. As the fears have diminished somewhat, stocks everywhere are rising and 5-yr Treasury yields are also rising.

Contrast the chart above with the second chart above, and you see how U.S. stocks (orange line) have been less affected by the panic than European stocks, and not as tightly correlated to 5-yr Treasury yields.  Europe remains depressed, but the U.S. economy is doing much better than many had feared: the S&P 500 has outperformed the Euro Stoxx 50 index by 30% since the beginning of May.

A collapse of the Eurozone financial market and economy could still occur, of course, and if it does it could have a significant negative impact on the U.S. economy. But in the meantime the U.S. economy is continuing to slowly improve and our financial markets are reasonably healthy. The world has known that a Greek default was essentially unavoidable for many months now, and prices are braced for the worst. Markets have been priced to the expectation that the U.S. was on the cusp of another recession, but it hasn't happened yet and I see no signs that it will. In the absence of evidence to confirm the market's fears, risky asset prices have little choice but to float upwards.


Gene Prescott said...


I am very interested in your analysis of this analysis:

Scott Grannis said...

Gene: I'm not surprised to learn that several dozen very large money managers own important pieces of the world's very large companies. But I fail to see what this means. The money managers employ many thousands of people to make the decisions about how to invest their money. Many of the large funds listed are index funds which invest passively. In the end, I don't think this analysis tells us anything meaningful.