Friday, June 22, 2012

Eurozone update

Two key measures of Eurozone risk have improved on the margin. The top chart shows 2-yr Eurozone swap spreads, and the bottom shows the yield on 2-yr Spanish government bonds. Both begin at the beginning of last year for some perspective.

The 10 bps decline in swap spreads in the past week or so is impressive by itself, and more so since it takes swap spreads back to the levels of late July last year, when the Eurozone crisis was just beginning to heat up. The ECB's liquidity injections have managed to restore a lot of confidence and liquidity to the Eurozone financial market, and that is an essential first step to allowing the crisis to play itself out.

The 100 bps decline in Spanish yields is also noteworthy, if only because it shows that the atmosphere of panic has been alleviated to some extent. Instead of worrying about how much one might lose if Spain defaults over the next year, the market seems to be paying more attention to how much extra yields one might ear if Spain doesn't default.

This chart of the Vix index shows that with the edge taken off of the panic in the Eurozone, U.S. markets have relaxed considerably. Implied volatility is still somewhat elevated, but it's nothing to be greatly concerned about.

Despite the fact that U.S. markets have calmed down considerably, the Vix/10-yr ratio remains very elevated. That's mostly due to the extremely low level of 10-yr yields, and that in turn is a reflection of the market's belief that the prospects for economic growth in the U.S. and the world are dismal.

Good and bad news: the risk of a catastrophe has declined significantly, but the market holds out very little hope for any significant improvement. Pessimism still reigns.


McKibbinUSA said...

Europe is collapsing...

brodero said...

The 2 year euro swap spread is at an 11 month low...this is more significant than the average investor
realizes...a move below 60 would be
very good...

Squire said...

Deleveraging in the private sector will continue.

John Short ad sinorazum said...

A bear market is around the corner. But first a huge rally to sucker in longs. We see it in the VIX, it never went above 30. There's no panic. A 3000 point rally to DOW 16000 would be a good top for a bear market.

William said...

Thank you for keeping track of these indicators, Scoot. I truly appreciate it.

Benjamin Cole said...

Greece would actually benefit by leaving the Eurozone and printing a lot of drachmas. Greek exports and tourism would benefit, and they could pay down their debts with chapter drachmas.

Bond investors would probably prefer a inflation scenario to a default scenario.

Benjamin Cole said...

From Davis Glasner's UneasyMoney....the Fed (and ECB and BoJ are intent on courting deflation, coming out of the worst recession since the Great Depression....if money is not tight, why deflationary expectations?

Yikes! Inflation Expectations Turned Negative Yesterday
Published June 22, 2012 expectations , inflation , monetary policy 9 Comments
In the wake of the FOMC’s decision Wednesday to ignore reality (and its own forecasts), the stock market dove yesterday. Inflation expectations, as approximated by the breakeven TIPS spread, also dove. And for the first time since March 2009, when the S&P 500 fell below 700, the implied breakeven TIPS spread on a one-year Treasury turned negative. I point this out just to illustrate the gravity of the current situation, not because there is a huge difference between the expectation of slightly positive inflation and slightly negative deflation.

Check out this chart for the one-year breakeven TIPS spread, this one for the 2-year, this one for the 5-year, and this one for the 10-year.

Chairman Bernanke has been reduced to defending the indefensible. Paul Krugman properly castigated the FOMC’s abdication of responsibility this week. Scott Sumner believes that Bernanke’s heart is in the right place, but his hands are tied, and is therefore unable to do what he knows in his heart ought to be done. If Scott is right, then Bernanke has only one honorable course of action: to resign and to explain that he cannot continue to serve as Fed Chairman, presiding over, and complicit in, a policy that he knows is mistaken and leading us to disaster.

John said...

"Europe" is not collapsing. The northern countries are strong. Europe needs a "Northern Euro" and a devalued "Southern Euro" to allow the PIIGS to export more and attract foreign investment.

Jim Cramor (Mad Money) says they need to do something other than austerity - they need to grow their economies. He's probably right.

William said...

Joseph E. Stiglitz, winner of the 2001 Nobel Prize in economics:
How policy has contributed to the great economic divide

"The Fed has consistently failed to understand the links between inequality and macroeconomic performance. Before the crisis, the Fed paid too little attention to inequality, focusing more on inflation than on employment. Many of the fashionable models in macroeconomics said that the distribution of income didn’t matter. Fed officials’ belief in unfettered markets restrained them from doing anything about the abuses of the banks. Even a former Fed governor, Ed Gramlich, argued in a forceful 2007 book that something should be done, but nothing was. The Fed refused to use the authority to regulate the mortgage market that Congress gave it in 1994. After the crisis, as the Fed lowered interest rates — in a predictably futile attempt to stimulate investment — it ignored the devastating effect that these rates would have on those Americans who had behaved prudently and invested in short-term government bonds, as well as the macroeconomic effects from their reduced consumption. Fed officials hoped that low interest rates would lead to high stock prices, which would in turn induce rich stock owners to consume more. Today, persistent low interest rates encourage firms that do invest to use capital-intensive technologies, such as replacing low-skilled checkout clerks with machines. In this way, the Fed may still be contributing to a jobless recovery, when we finally do recover."