GLOBAL CONTAGION / PRUDENTBEAR.COM ( HIGHLY RECOMMENDED READING )

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Global Contagion

by Doug Noland

November 25, 2011

The global Credit crisis took giant leaps forward this week. With even the euro region’s depleted “core” succumbing, crisis dynamics are now anything but isolated to “periphery” markets and economies. German yields rose after Tuesday’s “disastrous” 10-year bund auction failure. Italy struggled to sell short-term debt, with 6-month bills sold today at 6.50%, up dramatically from last month’s 3.54%. Fitch downgraded Portugal, with 10-year Portuguese yields surging 139 bps. As Irish 10-year yields jumped 150 bps to 9.53%, the market had to question the hopeful view that Ireland had endured the worst. Hungary’s 10-year yields spiked 105 bps this week to 9.44% after Moody’s downgraded the country’s debt rating to junk.

In the face of heightened global market instability, German 10-year bund yields actually jumped 30 bps and UK 10-year gilt yields gained 4 bps this week. Japanese 10-year JGB yields rose 4 bps and the yen dropped 1%, as the marketplace appeared to distance itself from another harbor that had been offering sanctuary from the global financial storm. .

As euro disintegration fears intensified, two-year yields became a market focal point throughout the region. Italian 2-year yields spiked 170 bps to 7.77% (7-wk rise of 360bps), with the Italian yield curve turning ominously inverted. Spain saw two-year yields jump 64 bps to 5.96% (3-wk gain 179bps). Banking worries weighed heavily on the euro “core,” with Belgian two-year yields jumping 120 bps to 5.04%. Two-year yields jumped 24 bps in France to 1.83% and 32 bps in Austria to 1.89%. Portugal saw two-year yields surge 329 bps to 17.14%, and Ireland yields jumped 158 bps to 9.35%. Greece’s two-year yields spiked to 110%. It became a panic. 

The markets are being forced to come to grips with a distressing reality. Germany likely has neither the will nor even the capacity to bail out the troubled euro region. And it’s reasonable to presume a similar view with respect to the ECB. Meanwhile, the markets are significantly scaling back expectations for the European Financial Stability Facility (EFSF). With market sentiment shifting dramatically against even the top-rated issuers of euro debt, dismal prospects for selling EFSF bonds will limit the capacity to leverage this bailout facility. Ongoing talk - of constitutional changes, greater European integration and more effective fiscal oversight, all engendering a more stable backdrop - rings hollow..

Not many weeks ago hopes were high that the EFSF would be equipped with sufficient firepower to help both recapitalize euro region banks and to “ring-fence” Spain and Italy. Today, the marketplace grapples with how a rapidly expanding hole in European bank capital can be contained, while essentially giving up on Italy and Spain. De-leveraging has already created alarming illiquidity throughout sovereign debt markets, boding ill for ongoing enormous refinancing needs for nations and financial institutions alike. .
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Hoping to bolster faltering confidence, the Europeans will be moving forward with another bank stress test. Increasingly, however, market fears have gravitated toward bank solvency, derivative and counterparty issues. This, along with the potential for nations to exit the euro – or perhaps even the complete disintegration of euro monetary integration – will create a backdrop where “stress tests” have only less market credibility. Increasingly, even the baseline optimistic scenario is calling for intense austerity at the national level and de-risking and de-leveraging at the banking system (and investor/speculator) level. Economic prospects have deteriorated rapidly throughout Europe and, importantly, in a “developing” world heavily exposed to a tightening of European bank finance.

Here at home, 10-year Treasury yields declined only 5 bps this week, perhaps foretelling a less potent safe haven bid in the world’s leading debt market. With market concern hitting the “safe haven” German bunds (and gilts and JGBs), I would suggest the global crisis did indeed take a giant leap toward a more globalized crisis with sights on our and others’ debt markets. Certainly, the failure of our Congressional deficit “super committee” provides ample fundamental reason for the markets to fear that debt worries are drifting ever closer to our shores. With Fed and global central bank operations having completely distorted the functioning of our government debt markets, I’ve always assumed that Washington would run reckless polices until that day when markets imposed painful discipline. .
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There is less complacency regarding the ramifications for the European debt crisis. The marketplace now better appreciates the systemic nature of what is unfolding. Problems at Europe’s “periphery” will not be easily resolved by German and French guarantees, eurobonds, a leveraged bailout fund, the ECB or the Chinese. The markets recognize there will be no quick fix, while worries mount that global finance and economies may be much less sound than earlier believed..
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Increasingly, the marketplace is moving more in the direction of the bearish view of things, a viewpoint not long ago disregarded as misplaced and alarmist. I have worried that the market’s expectation for German and ECB capitulation has been poised for disappointment. It has been my view that the markets have been much too complacent with respect to debt crisis global ramifications. While the issue is not yet settled, I see increasing confirmation that “developing” Credit systems and economies are much less resilient than the markets have assumed. I am more confident in the analysis that several years of rampant excess have left the “developing” world much more vulnerable to the unfolding crisis than it was back in 2008. 
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The backdrop is fraught with extraordinary uncertainty. It appears that Greek debt restructuring is coming to a head. Huge loses will be imposed on Greece’s bond holders, while efforts by the ECB and others to ensure that a “voluntary” write down would not trigger a payout in the Credit default swap (CDS) marketplace will be in vain. The EU and IMF must soon make a decision on funding the next bailout tranche. 
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The markets are now on daily watch to see if things continue to spiral out of control in Italy and Spain. The high degree of systemic stress that arose this week has market participants conditioned to expect a policy response. With the euro and “developing” currencies under intense selling pressure, the dollar index jumped to its high for the year. Dollar strength further pressures de-leveraging, de-risking and the reversal of “dollar carry trades” (short the dollar and use proceeds to leverage in higher-returning global assets). Some analysts, including myself, view dollar strength as raising the probability for QE3 operations from the Bernanke Fed (additional quantitative easing would be expected to pressure the dollar lower). 
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I don’t believe that the expanding nature of global market illiquidity is garnering the attention it deserves. And it’s difficult to envisage a scenario where the liquidity backdrop doesn’t deteriorate further. European banks are likely still in the early innings of their historic retrenchment. With financial implosion risk seemingly growing by the day, I fear an escalating crisis of confidence with respect to derivatives and counterparty issues. This is a major issue for global financial institutions and the vulnerable global leveraged speculating community. 
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Whether it is CDS or derivative protection more generally, a deteriorating risk versus potential return backdrop would seem to point to the ongoing liquidation of risk asset exposures attained through - or hedged by - derivative products. For too long, market participants have tolerated illiquid holdings because of the perception of readily available liquid and inexpensive derivative “insurance”. This epic market distortion created egregious speculative leveraging throughout the global system - and attendant acute fragility that is increasingly on display. 
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I would not be surprised by some announcement of concerted international policymaker measures to bolster confidence in global market liquidity. The financial breakdown scenario is no longer outrageous. The global crisis has afflicted the core, with literally tens of Trillions of sovereign debt and banking system obligations now in the markets’ bad graces.
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