Busch: European Debt Crisis
Global financial markets continue to be roiled by the complex and alarming newsflow surrounding the European debt crisis. But the trading strategy for the upcoming votes on the bailout is straightforward.
The hydra-headed European financial crisis is making the 2008 US financial crisis seem simple by comparison. The rumors were coming fast and furious Friday, from talk of Greece announcing a default or Greece releasing a list of private sector banks willing to take losses on their Greek debt, to Greece announcing a pullout from the euro zone. As of this writing, all appear to be untrue. Also as of this writing, all appear to have had a dramatic negative impact on the euro, the DAX and the European banking system.
On July 21st, European leaders approved not only a new bailout for Greece, but also a new structure for the euro zone's bailout facility, or EFSF (European Financial Stability Facility). Greece then agreed to follow the IMF/EU austerity program and approved the plan with a parliamentary vote. The major problem is that the euro zone member countries went on vacation in August and didn't ratify the July 21st plan. This vacuum has been filled with foul smelling rumors, innuendo and speculation. Sadly, it has also been filled with facts that show a deteriorating Greek economy, expanding credit spreads for both sovereign and banks and disintegrating cohesion amongst the European policy makers over the path forward.
At its heart, Europe's issue is a political one. Specifically, the structure created was a financial union that lacked a political mechanism to oust members who didn't meet the accord's rules. Remember, the European constitution does not have a mechanism to toss out members who break the rules. Subsequently, almost all member nations have broken the rules of agreement, but the periphery did it in grand style with debt-to-GDP exploding as growth rates fell. This created conditions for a debt death spiral that was fulfilled when Greece, Ireland and Portugal all required bailouts. Yet, the bailouts didn't resolve the issue fully as those nations had to approve, enact and follow the austerity programs that came with the bailouts. But their declining GDP levels meant declining tax revenues and declining ability to service their increasing debt loads. And the debt spiral accelerated.
With the acceleration, member nations not requiring bailouts began to be wary of the prospects of bailed out nations fulfilling the terms of the agreement. Simultaneously, bond investors reflected their concerns by selling sovereign debt and raising the costs of re-funding for bailed out nations, thereby delaying the return of those countries to the capital markets. In turn, the markets began to assess the linkages between the sovereign periphery and domestic banks. What did the banks have on their balance sheets and could they absorb a dramatic write-down in value of those portfolios? A key component from the Greek bailout was for a haircut to private investors who owned Greek debt. This meant that other bailed out nations may impose haircuts or losses for private investors. And the debt spiral accelerated.
The spiral was eventually enlarged to include the much larger economies of Italy and Spain. The 10 year yields for Italian and Spanish debt rose rapidly to levels perilously close to levels reached by periphery countries just before they had to be bailed out. As most noted, Italy had a larger debt load at E1.8 trillion than the entire periphery combined and would greatly exceed the current EFSF fund. This led to more pressure on politicians of these nations to enact austerity measures and for the European Central Bank to re-start its SMP or sovereign bond buying program to stabilize rates. Initially, this was successful as 10 year rates dropped to 5.0% for both Spain and Italy. However, Italy backed away from initial austerity plans and spooked investors. Although the Italian parliament has subsequently passed a strengthened plan, the damage was done and rates rose again. This prompted another round of SMP, but with a casualty: ECB member Stark resigned in protest.
As of this writing, credit spread indicators are rising rapidly for Europe and reflect fear of what may happen. During the 2008 US financial crisis, we watched the spread between 3 month US LIBOR and 3 month overnight index swaps (an instrument that reflects markets expectations for Federal Reserve overnight rates) explode from 11 basis points to 365 basis points. The European equivalent is Euribor-OIS of 15 basis points on May 1st to 83 basis points today. Over the last three weeks, cash holdings at the European Central Bank have risen from around E24 billion on July 1st to E166 billion on September 8th . Credit default swaps for Italy and Spain are now above 400 and reflect bond market fears over rising default risks. The Bloomberg European Banks and Financial Services Index has fallen thirty percent over the same time frame.
The path forward is complicated due to the constitutional constraints mandating member votes on the new bailout facility. Now, we will be subject to not one TARP-like vote, but numerous votes all with the potential to shut it down and re-start the process. Remember, TARP was voted down the first time it was brought up in the US House of Representatives, leading to a massive drop in US stocks. The best news is that France has passed the plan through their Senate. Finland, Netherlands and Germany must all hold votes shortly and the outcome will drive the financial market values from stocks to bonds to currencies.
The markets are likely to sell risk upon the announcement of when a vote will be taken and buy risk should the outcome be positive. Finland, Netherlands and Germany are the key three to monitor for issues. The Dutch are expected to vote next week with the Germans voting September 29-30th and the Finns following in October. Watch to see if votes begin to be delayed beyond September and October as that would clearly indicate two critical points. First, there is a serious problem with the member country passing the program. Two, there is a growing possibility that the Greek bailout plan won't be approved, that Greece will be forced into default, and Greece will be forced out of the union.
Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a contributor to CNBC's Money in Motion Currency Trading.You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch .
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