I believe that the today’s EU debt crisis is somehow more difficult to invest if comparing to previous 2008 US financial crisis. Don’t get me wrong, I didn’t invest around 2008, my first time of joining the market is 2009, and I don’t mean just simply looking at the chart and say: “hey this is an easy investment” – I know deeply how a steep up or down chart profoundly doesn’t mean easy investing as it looks. However the situation now seems more controversial than in 2008 and the markets are giving quite mixed signals about what’s going on.
Here is a how the market reacted in 2008:
– Global listed equity markets: S&P, Dow, FTSE, Nikkei – and other major global equity indices were down sharply from end of 2007 with pretty high correlation.
– Currency market: Dollar got shot up as people sell everything they can in international markets and return to US treasury.
– Bond markets: People bought US treasury fiercely, pushed bond prices up and dampened bond yield down, especially short-term instrument 2Yr.
– Emerging countries listed equity: India, Brazil, China, Thailand, … booked a pretty heavy loss and government bond yield surged followed the global sell-off.
Now a global sell-off like that seems having a low chance to happen again. The confusing characteristic of the markets this time, I think, is there wouldn’t be a high correlation of the sell-off like what the markets did in 2008. There will be heavy downward pressure some spots, and there will be highly volatility in some other spots. The markets probably won’t go pace-to-pace this time, and that’s what annoys the investors.
Take a step back, leave all the noises behind – this is how situation in Europe:
1/ EUR and ECB came in from 1998. This gave poor countries at EU’s periphery access to low borrowing cost which is an advantage of rich EU’s core countries like Germany and France.
2/ Debt level and leverage went high, everybody was happy, nobody believed such a strong cooperated from the Euro zone there would be a sovereign default.
3/ US mortgage-backed securities market gave early signals of an earth quake in 2005. Smart money started to sell off risky sovereign bonds from weak countries in EU’s periphery and moved their money back to France and, mostly, Germany. Bond yield discrepancies between poor and rich of Europe started to spread.
4/ US Financial crisis spread in 2007 pushed EU banking system to trouble – in order to save the EU banks, EU countries had to bail them out – this made EU’s government sank more heavily in debt.
5/ Bond yield, understand simply, is the cost of borrowing money from perspective of borrower and the price of lending money from perspective of lender. Bond yield went high pushed the borrowers (PIIGS – Portugal, Ireland, Italy, Greece and Spain) to pay more interest cost to borrow money to refinance their activities.
6/ Bond yield goes to a specific high level, and then people believe the government can’t have the ability to pay back anymore. The specific level here is 7% from historical reactions. When the 7% level is reached, people started to sell fiercely as they want to stop their losses from no-longer-valuable-bonds. This, in turn, pushed bond prices sharply lower and bond yield even higher.
7/ Bond yields get too high and the governments can’t borrow more money to finance their activities, no pay-checks to pay their labors, etc. This makes the chance of default on their debt even higher. It’s the vicious circle: Higher cost of borrowing => can’t pay back => no money => can’t continue growing => higher chance to default => no-one dares to lend them money => higher cost of borrowing => can’t pay back …
8/ To ease the situation, France and Germany led a rescue plan on recapitalize banks, decrease leverage, and boost EFSF – Euro Financial Stability Facilities to $1.4 trillion. EFSF’s money will be used to buy back (i.e. bail-out) sovereign bonds from EU periphery countries (PIIGS) when global investors sold them off. This contributes to the other side of the equation, reduce bond yields, give the PIIGs more time to do austerity to pay back their obligation in longer time frame.
9/ Yet – EFSF needs investors such as Brazil, China, US, Japan, Middle East countries… Therefore EFSF exposes to the risk of no investors. This is contradictory to US’s case: Fed can just print money and bail their financial institutions out. European Central Bank (ECB) only has one mandate: price stability, therefore ECB explicitly refused to print money and bail the PIIGS out. EFSF comes in scene and expose to external risk. Fed didn’t.
10/ No-one wants the PIIGS to leave Euro zone. If they leave, they will again have a central bank and use their own currency. This means they can print money to pay their debt. Two ideas come up: Who know what’s value of their money tomorrow? and who know how much they will print to repay their debt? So there is an issue on determining currency value on foreign exchange market and confidence risk regarding that currency.
11/ Even if now the PIIGS get bail-out and have more time to live. They have to go through concisely monitored austerity by ECB, IMF, and EC. Their growth seems to be deteriorated dramatically followed the austerity. Therefore even they have more time, they can’t make enough money to repay their debt. EFSF therefore just buy more time, not the solution. Risk comes especially in 2012-2014 when there is a lot of debts need to be refinanced. Whether EFSF would continue to buy these new debts? If the austerity adopted now doesn’t work till then, whether IMF gives up with these countries?
Base case implications:
1/ US’s equity: Estimated of 30% of S&P’s companies revenue rooted from EU, this is business risk. International financial institutions with exposure to EU would get hit: Credit risk, yield spread risk, financial risk – take the case of MF Global. However the exposure seems not to be so high as the leverage of US banks were quite modest comparing with EU banks – but who knows there will be some hidden relationships or off-balance sheet debts, financial world is highly connected. Even though US’s recovery is slow, US economy is getting better everyday – the former factor pushes US equity markets down, meanwhile the later factor pulls US equity markets up. Maybe US’s equity wouldn’t be so dampened this time, they would be dampened, but not so dampened like in 2008. Maybe Dow/S&P/Nasdaq would face some wild volatility along the way down of EU’s equity but then gradually get better and get off the correlation with EU’s equity and EUR/USD.
2/ Foreign exchange market: EUR/USD is having a high (0.60-0.80+) correlation with S&P. This is weird and supposed to be short-lived: fundamentally US economy is getting better and EU situation is getting worse. Yet the situation with EUR this time will be dramatically different with 2008 and 2009 EUR sell-off. EUR/USD this time faces some unexpected strong bound and this phenomena would likely to continue. As 2008 case, USD get stronger as investors sell everything they had in hands and returned the off-shore USD back to the US. This time EUR is in trouble and European investors would maybe sell everything they have and repatriate back to EU. This creates a force of EUR strength on countering the USD strength that would make the chart be very choppy and increase the risk of being EUR short-squeezed. JP’s exporters would maybe continue to suffer follow Japanese Yen appreciating as safe-heaven if the debt crisis trigger as no government can fight back the force of global investors. Besides, Japan faces a harder situation comparing with their colleagues at Swiss: Japan economy has much more international relationship with the world that makes their unilateral intervention less fierce and, hence, less respected.
3/ Emerging market: EU is the global biggest investor to emerging market. Repatriating force would maybe push the emerging markets equity lower and surge emerging sovereign bond yield in the short-term. Business risk of emerging countries are also alarming: most of emerging countries employed export-led growth with two main export markets are US and EU. It’s scary now to see a dangerous EU and a so-weak US’s recovery. In order to adapt with this, emerging and frontiers countries must rely on domestic consumption as well as redirect their export destinations which are both hard to do work.
4/ Bond markets: Bond market is the heart of this time crisis. As things get more tense, people would sell off risky asset and return to safe heavens: Japanese bonds, Germany bonds, and US treasury. US treasury would maybe see a wider yield spread between 2Yr maturity and 10-30Yr maturity as the movement is short-term. In longer term, the flawed dollar and de-leveraging US economy is still the major theme.
In short, there is 3 major types of bond yield spreads to be considered as the key barometer of EU debt crisis: (1) Maturity spread of Italy, Spain, and France – As the case of Italy, 2Yr bond yield is now higher than 10Yr bond yield – this implies Italy is facing liquidity risk, not solvency risk and also short-term speaking, money are fleeing out of Italy. (2) Yield spreads between EU countries, especially between Germany vs Italy/Spain/France – the market development previous days shows that contagion risk has spread from Greece to Italy, now is striking both Spain and France. Yet Germany 2Yr bond is also being sold quite notably, I don’t know why but this is maybe a signal that money flow is getting out of EU as Germany is EU’s last wall. (3) Yield spread between US and Germany – my hypothesis is money will flow from risky EU’s periphery countries to Germany, if EU situation continues to be bad, they would run out of Germany and head to the US and Japan.