As acceptance of at least a partial Greek default grows among EU leaders, all PIIGS bond rates have been spiking over the past week to reflect increased risk premium now that the assumed EU put is gone. As noted in last week’s post, PRIOR WEEK’S LESSONS FOR NEXT WEEK: SEISMIC SHIFT IN EU DEBT RISK once you undermine the assumption that the EU will protect PIIGS bondholders from losses, then contagion risk is on, and private investors will shun PIIGS bonds, or at minimum drive up PIIGS bond yields to reflect much greater risk now that assumed EU bailouts no longer there.
Thus no surprise that PIIG bond yields spiked. Moody’s downgrade of Ireland’s credit now means 3 PIIGS have junk bond ratings, Greece Portugal and Ireland. Meanwhile, the two others, the too big to bails, Italy and Spain, have bond yields at record levels.
Of most concern was that now, for the first time since the EU debt crisis began, Italian bond rates were soaring and bank stocks tanking.
Since the start of last week the week Italian government bonds have been in freefall. This sudden spike in yields comes at a particularly bad time, because Italy needs to refinance over €60 billion of bonds in the coming 6 weeks. With yields on its securities materially higher than the period prior, Italian Treasury will see its debt service costs soar in the near term, making fiscal adjustments much more difficult.
Why the sudden loss of confidence over the past weeks? Nothing about Italian fundamentals had really changed.
The best summary of the situation I’ve read was in an article from the German newspaper Die Zeit Understand The Banks And You Save The Euro (via seekingalpha.com, in its always-must read Global and Fx currents section). The following is a summary of the articles key points, with a few of my own observations added.
- While Italian government debt may well be high, unlike other countries, it’s not getting any higher. The banks are healthy, as are private household finances. So why are the markets panicking, and why now?
- While there may be some truth to EU politicians blaming speculators, Wall Street, or US conspiracies against the EU or EUR to preserve the dominance of the USD (although US policy in recent years has clearly been indifferent to the fate of the USD), in fact the real cause of the sudden spike in Italian and other PIIGS bond yields, and collapse in and confidence is the EU’s own recent policy change.
As I noted in last week’s weekly review and preview, Last Week’s Lessons for This Week: Seismic Shift in EU Debt Risk Part 1, once the EU changed its mind about protecting bondholders from losses and removed the implied EU guarantee of PIIGS debt, the risk for these instruments rose dramatically. So of course that was quickly reflected in PIIGS bond yields. That in turn makes a PIIGS default more likely, and once we get one, the rest will follow, as will many of the banks holding those bonds or those that insured them, as credit markets boycott PIIGS debt.
The idea is not new, it’s just something the EU’s voters don’t want to hear.
As ECB President Trichet has warned, attempts to impose losses on PIIGS bondholders that have been financing the EU’s debt will scare away these vital funding sources just when they’re most needed.
Continuing with the articles key points:
- In sum, ironically, through this decision to inflict losses on the PIIGS bondholders, the countries of Europe are scaring off exactly the financiers needed to save them.
- Tension in the EU began its most recent leg higher when Moody’s downgraded Portuguese debt, largely because, per a Moody’s note to clients:
“the increased likelihood that the participation of the private sector will be demanded” in the pay-out of new emergency loans. What worries the rating agency is what the German federal government, above all, is determined to push through: contributions by banks and insurance companies to finance the rescue package. Voluntarily, but if need be under the threat of coercion. That’s what Merkel and Schäuble have promised the Bundestag – and the unruly members of the coalition government.
And that’s the problem. Banks and insurance companies ultimately are paid for investing their clients’ money profitably. If losses loom, they must draw back. It played out that way in Greece and Ireland, and it’s playing out that way now in Portugal and Italy.
Led by the Germans, the Europeans have manoeuvred themselves into a strategic corner. Either they do without the short-term involvement of the big money houses and alienate their parliaments, or they stand up to Wall Street and risk massive capital flight. Either way, with each passing day the governments spend dithering, the uncertainty increases. Hence the crisis…. John Taylor, a foreign exchange speculator, compares the common currency to a chicken that’s had its head chopped off and is still running around for a while, before falling over dead.Divided, hesitant, dithering: that’s how the investors see Europe, and that’s why they prefer to invest their money elsewhere…..So goes Europe into the end-game of the euro, deeply divided… it is also clear that the Europeans can never come up with all the capital it needs to finance the indebted states. And that is why Europe needs precisely those financiers it is driving off.
See the rest of the article for more details.
Contagion, Global Crisis Risk Way Up
As we’ve noted before, this is a global crisis potentially much greater than that which followed the Lehman collapse.
Lehman Bros was a large bank. Spain and Italy, together represent about 35% of the EU’s GDP, are far too big to bailout if they’re unable to access credit markets at affordable rates. As in 2008, once again, banks will be so suspicious of one another’s solvency that interbank liquidity will seize up and detonate another collapse of the unregulated derivatives market, especially Credit Default Swaps (insurance on bond defaults) as insurers are suddenly overwhelmed with unanticipated claims they can’t pay (from this black swan event that their risk models didn’t anticipate), and voila, lots of insolvent banks, barring another round of bailouts and money printing to fund them. Virtually all major US banks heavily exposed through these, though not necessarily on EU debt.
Hello Global Double Dip, or Depression?
If the EU debt crisis metastasizes into a wave of defaulting nations and banks, well, a few likely consequences include:
- Eastern Europe, heavily dependent on the Western European banks for credit, gets sucked down
- China losses its biggest export market, goodbye China miracle
- Major banks worldwide, certainly in the US, are once again destabilized, so the troubled US economy takes another hit
LESSONS AND RAMIFICATIONS
Until credit markets gain clarity about the extent of losses they will bear, contagion fear and risk of sovereign and banking defaults continues.
What To Do?
For the longer term (positions to be held in months or years) shorting the EUR is an obvious choice, either directly by selling it vs. safer currencies, like selling the EURUSD, EURJPY, EURCHF, etc, or via Euro short ETFs like the EUO, or via weekly or puts on monthly EURUSD binary options. We like the monthly expirations because they allow more time for the longer term trend to assert itself.
For the coming week, however, taking positions on either the EUR or USD is treacherous. Between potential good and bad news on both the EU debt crisis and US debt ceiling debate, both currencies could make dramatic unanticipated moves if either situation shows deterioration or progress towards resolution. Thus we’d avoiding trades on either currency for now, especially on the EURUSD.
However, as Graham Sumner recently pointed out in his private wealth advisory newsletter, if the EURUSD breaks decisively below its 200 day MA, (I use the EMA) it that is usually a signal for a tradable move downwards, depending on how severe the EU crisis is at the time. Of course this is not unique to the EURUSD, a drop below the 200 day moving average is generally a bearish sign for most assets.
As the chart below shows, 1.4000 is the key support point to watch.
EURUSD DAILY CHART COURTESY ANYOPTION.COM 03 jul 15 1619
At 1.4000, we have both:
- An historically extremely important psychological level of support or resistance. Decisive breaks above or below tend to continue for months.
- The 200 day EMA currently sits around 1.4000.
Thus if the EURUSD makes a convincing sustained move below 1.4000, we’d consider going short the EUR one way or another.
Obviously officials everywhere will do all they can to stop that. So at minimum, in the near term, we expect more promises of bailouts, money printing, further banking accounting by suspension of disbelief rules to preserve a façade of solvency, etc. It may yet defer the inevitable collapse when bond buyers disappear. Thus we resist the temptation to go short the EURUSD until the above signal.
Gold, silver, and other fiat money hedges are clear winners here from the money printing angle. As recessions tend to be deflationary, the only real major safe haven currency, the CHF, may well keep rising. The JPY and USD might too, though their underlying economies have enough fundamental problems to limit their gains in all but the worst panic scenarios.
See here for a more complete set of recommendations via Deutche Bank on how to prepare for a contagion scenario
Second Annual EU Bank Stress Test Farce: 3 Bad Signs
The much anticipated European stress test results came out at noon and as predicted or leaked, only 8 banks failed. The Euro bounced higher, then fell.
This makes sense, because the tests were once again a fairly transparent PR attempt, and not a particularly successful one, given that the reality is so bleak. However markets may use it as an excuse for a continuation of Friday’s bounce off near term support. Here’s what’s troubling:
- The report that accompanied the results emphasised 20 banks would have failed if they hadn’t raised a large amount of capital raised in the first four months of this year.
- While only 8 banks failed the tests, a further 16 barely passed, with Core Tier 1 Capital ratios of between 5 and 6 per cent. That wouldn’t be so worrying if the worst case scenarios tested included the very reasonable possibility one or more sovereign defaults, which indeed Germany continues to insist on through its demand that bondholders absorb losses. However…
Even the European Banking Authority (EBA) “suggested” that the 5% Tier 1 capital ratio would be insufficient in the case of a sovereign default (as if once there were one more wouldn’t follow). Note that sovereign debt is still treated as safer than other comparable credit risks, though the report recommended ending this special treatment.
In other words, at least 21 of the 91 banks tested may not survive an eventual Greek default, and other PIIGS bonds defaults that could easily follow as they find themselves locked out of frightened credit markets).
- Meanwhile bond yields continued to climb higher all day in Italy and Spain and of course Greece. The bond vigilantes are winning, now that that the EU plans to sock them with losses, and for the second straight summer present suspicious tests of bank health.
LESSONS & RAMIFICATIONS
Given the above, next week’s July 21 EU Summit ,where EU leaders are expected to reach a Greek rescue deal, becomes a significant risk event as long as German officials continue to insist on inflicting some degree of loss on the private sector losses, i.e. allowing Greek bond defaults, despite the seemingly unavoidable risk of contagion that would bring, as the past week’s events have shown. Thus far the ECB recognises this danger and remains opposed to allowing any default.
As long as the risk of any kind of default is removed, we expect more of what we saw last week – risk assets in retreat and rising PIIGS bond yields as markets continue to price in rising contagion risk.
As with the last EU crisis in 2010, German leaders appear ready to play to German voters until they believe the contagion risk is obvious enough for German voters to understand that there was no choice but for their leaders to protect the banks holding the PIIGS bonds. Last year’s crisis involved only Greece. Since then, Ireland and Portugal have taken bailouts too, and now yields are at record rates for Spain and Italy.
US Debt Mess
BERNANKE QE 3 HINT
Despite the growing threat of a new EU debt and global banking and market crash, this wasn’t the only market mover last week.
Global markets also moved by Bernanke semiannual 2 day testimony in which on Wednesday, the first day he suggested that QE3 or other stimulus on the menu if US economy shows further weakness and inflation remains quiescent. The USD tanked, stocks caught a dead cat bounce, the battered EURUSD rose on USD weakness, and gold spiked higher at the mere hint of more USD devaluing QE 3.
On the second day, Thursday, Bernanke reversed somewhat the effects of his remarks, saying that QE3 was not yet actively under consideration. Predictably Stocks reversed, the USD rose, the EURUS fell.
Ramifications And What To Do
While the possibility of QE 3 has now officially arrived, and it markets moved both days on rising then falling QE3 hopes, until it’s precise nature are better known, we don’t expect it to influence markets greatly in the near future unless conditions change so radically that it’s likelihood noticeably rises or fades. The Fed will probably need to see another 2-3 months of poor economic data before reaching a decision, and would need to convince its opponents why a third stimulus program will succeed where the past 2 have failed. As we’ve noted before, this is a balance sheet recession in which the private sector is cutting debt, thus it’s hard to understand why increasing liquidity should somehow increase spending when debt cutting demands the very opposite.
With a weak US economy and more stimulus a rising possibility, the USD’s only hope to avoid a continued downtrend is a continuation of the EU debt crisis AND closure on the debt ceiling debate.
DEBT CEILING UNCERTAINTY
In addition, the President and Congress remain far from any agreement to cut the US deficit and raise the US debt ceiling in order to avoid an August 2Nd default. Credit ratings agencies have warned that without agreement on both fronts, the US AAA credit rating could be cut. Thus markets are very concerned that continued intransigence on both sides that could lead to a failure to reach agreement on either one or both issues. The 3 likely outcomes remain:
1) A ‘grand bargain’ which cuts the deficit is cut by around USD 4 trillion over a decade through a combination of spending cuts and revenue increases – unlikely given the current divisions
2) A more modest deal that cuts the deficit by only 1.5-2.0 trln.
3) A minimum deal to avoid default with only a debt limit increase but no deficit reduction.
Ramifications & What To Do
While we believe some agreement will be reached because none of the participants wants to share blame for the chaos and credit downgrade that could follow a failure to reach agreement, so the USD’s overall strength vs. the EUR over the longer term appears likely. However until such time both risk assets and the USD will remain vulnerable vs. other safe currencies and precious metals.
While some bullish US earnings from Google and Citi were cited as excuses for a bounce off near term support Friday for US stocks, earnings and economic data were essentially drowned out by the above market drivers last week.
See Part 2 on the coming week’s likely market movers and why any break below the 1300 area on the S&P 500 would be particularly significant.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?