Europe: The Root of the Correction

by: Bernard Thomas

As today is Norwegian Syttende Mai (Norwegian Constitution Day) I will start off discussing Europe (FYI: Norway is not part of the contagion fears or the EU for that matter).

I have belabored my opinion that LIBOR probably won't rise very far, very quickly. What has happened? LIBOR has almost doubled during the past two months. However, this is not due to positive economic expectations (which would lead to Fed Funds rate increases), but it is due to jitters in the interbank lending market. Banks are less confident in lending to other banks, especially European banks. Could this trend continues? Sure, but I don't think LIBOR will move dramatically higher unless the contagion in Europe spreads. I think even the Ostriches overseas will get their heads out of the sand before it spreads that far.

This does not mean I think Europe will bounce back and challenge the U.S. for economic dominance and reserve currency status. Austerity measures will suppress growth and discord among the European populace will shake investors confidence.

Many investors and market prognosticators have become frustrated with the inability of the EU to jawbone and "TARP" its way out of its crisis. This should not be surprising as it was the stress tests and not TARP which finally restored investor confidence. Why doesn't Europe simply stress test its member countries? When the U.S. stressed tested the banks it had a good idea that they would pass. The EU leadership apparently lacks the same confidence in some of its members.

Today's foreign securities purchases show that in March, foreign investors were already seeking the safe harbor of U.S. Treasuries. They have not let up since. This continuing trend should keep U.S. long-term rates relatively low. It is the prospect of low rates and a heavily stimulated U.S. economy which has put the brakes on the stock market decline. However, with the dollar gaining strength, U.S. exports will see their price advantage diminish, if not disappear. The U.S. economy is going to have to grow on substance rather than speculation.

I have fielded questions during the past week regarding the divergence of Treasury yields and credit yields (bonds and preferreds). They have indeed moved in opposite directions. This should not be surprising. During times of crises or correction credit spreads widen. What has happened recently is that investors have been lightening positions of corporate bonds, especially financials and have been buying Treasuries. When the markets settle down the reverse should occur. Investors must understand that all rates are not created equal (long, short, credit, etc.) and that corporate bonds and preferreds ARE NOT interest rate products. They are credit products.

I would be happy to explain the difference.

Trivia: How many government bond issues does Norway have outstanding?

Disclosure: Author holds long positions in TBT, C, BAC, SIRI, FREprZ

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