Thursday, December 1, 2011

Eurozone pulls back from the brink

This chart gives an overview of the current state of 2-yr yields in the PIIS countries (I exclude Greece because there appears no hope of avoiding a significant default, with 2-yr Greek yields trading at about 120%). One thing stands out, and that is the recent decline in yields on Italian and Spanish debt. They have pulled back from the 7+% brink (France down about 100 bps from its recent highs, Spain down 130 bps), but they are still elevated. Both countries appear serious about controlling spending and reducing their deficits, but it will take a long time to convince skeptical investors that these countries have really changed their spendthrift ways. Eurozone 2-yr swap spreads have only declined marginally, from a recent high of 115 bps to 109 bps today; Europe is still facing enormous challenges.

The chart above shows that 2-yr French yields have sharply reversed, an indication that France remains almost as solid as Germany and is not likely to turn into another Italy. French spreads to Germany had blown out to 140 bps a few days ago, but are now back in to about 75 bps. That is a very welcome improvement, but in a normal world the spread would be close to zero.

Meanwhile, Eurozone equities are up some 15% from their recent lows. This is a palpable sign of relief—a decent pullback from the brink of an awful abyss. But it is probably premature to conclude that conditions in Europe will continue to improve in a straight line from here, even though its tempting to think. As a long-term investor, however, I think it makes sense to bet that the Eurozone economies will eventually do the right thing, and that makes today's equity valuations very attractive.


Benjamin Cole said...

The Eurozone is another example of bad government policies--too much government, and too tight money.

Japan has shown us the tight-money world. Europe has shown us the too-much-government world.

I hope we can do better in the USA.

Jon S. said...

I wish I could be more optimistic, but the numbers show a much worse situation than analyzed here. The PIIGS debt is about $7.2 trillion. The EFSF has a bit more than $400 billion to deal with this debt problem. Any of the current schemes to leverage this paltry amount to deal with the underlying current -- and future -- debt are longshots, at best.

Can they grow their way out of this? Germany, the protagonist in this Italian opera, already has a debt-to-GDP ratio of 83%. If they proceed with any of the bailout options now under discussion, that ratio will rise by a factor of 2-3, higher than Japan's. German and other European banks will be in huge trouble, and German economic growth, for obvious reasons, must contract under any of these scenarios. Contagion throughout the Eurozone, in China, and of course in the US will spread.

Political will to stop this does not exist. Not in Europe, where in the past few years public debt has grown despite their leaders knowing full well the disaster that lay ahead. Doesn't exist here either in the necessary qusntity, although we are in a better position to grow should spending actually get cut and regulations/entitlements get seriously reformed.

We are witnessing a schizophrenic market wildly swinging from fear to hope on the slightest rumor of Eurozone leaders' plans to discuss what the plan ought to be .... but a simple painless fix does not exist. Day traders can get in and out on this basis and make some money, but expecting the market to enter bull territory for the long haul based on metrics that don't include macro (ie, governmental) probabilities is unrealistic.

John said...


The republicans are said to be drafting a bill to prevent the IMF from aiding Europe. I would be interested in your take. See


Scott Grannis said...

John: I think the Republicans are on the right track. An IMF bailout of Europe is just throwing taxpayer money down the drain and it only delays the inevitable adjustments that must be made.

Public Library said...

Every economy is planned. This traditionally has been the function of government. Relinquishing this role under the slogan of “free markets” leaves it in the hands of banks. Yet the planning privilege of credit creation and allocation turns out to be even more centralized than that of elected public officials. And to make matters worse, the financial time frame is short-term hit-and-run, ending up as asset stripping. By seeking their own gains, the banks tend to destroy the economy. The surplus ends up being consumed by interest and other financial charges, leaving no revenue for new capital investment or basic social spending.

This is why relinquishing policy control to a creditor class rarely has gone together with economic growth and rising living standards. The tendency for debts to grow faster than the population’s ability to pay has been a basic constant throughout all recorded history. Debts mount up exponentially, absorbing the surplus and reducing much of the population to the equivalent of debt peonage. To restore economic balance, antiquity’s cry for debt cancellation sought what the Bronze Age Near East achieved by royal fiat: to cancel the overgrowth of debts.

In more modern times, democracies have urged a strong state to tax rentier income and wealth, and when called for, to write down debts. This is done most readily when the state itself creates money and credit. It is done least easily when banks translate their gains into political power. When banks are permitted to be self-regulating and given veto power over government regulators, the economy is distorted to permit creditors to indulge in the speculative gambles and outright fraud that have marked the past decade. The fall of the Roman Empire demonstrates what happens when creditor demands are unchecked. Under these conditions the alternative to government planning and regulation of the financial sector becomes a road to debt peonage.

John said...

Thank you, Scott.