European bond markets are “restless” again – great euphemism, that – as Portugal is beginning to experience even more severe problems with spreads on bonds, and the actual sale of sovereign debt than anticipated. Commentators and some bondholders are surprised. Well, I picked three of the four underdogs this weekend and did well and only lost on the Chiefs game. I forgot to factor in experience – and so are the markets. These bond traders have no collective experience of a sovereign debt crisis in a major country – currency crisis yes, debt crisis no – and they also see the EU and ECB actions in 2010 as guaranteeing there can be no real crisis. So they are surprised when bond yields increase and the cost of buying derivatives to insure these bonds soars.
Why the surprise? Not only was this predictable, the future is predictable as well.
The back-story of any forecast is straightforward. Unlike the US, the Europeans are first, on the ground, the EU and ECB are unable to completely backstop a large crisis, they do not have the political support to expand the money supply enough, at least not at this juncture. The unwillingness to provide 100% guarantees for bank debt is of particular importance in Spain, where the problem is real estate debt held in private hands that is well below water with inadequate capital in the country to clear up the mess. And the EU and ECB do not have enough euros to bail out Spain.
Second, in recent weeks, the same EU and ECB bankers and ministers, led by the Germans, are telling everyone they will not backstop bank bondholders after 2013. Well, plenty of banks hold plenty of sovereign debt that is somewhat dodgy (when writing about Europe I find it fun to throw in sophisticated terms from the British form of English), which means regulators are saying we will, indirectly, not back up sovereign debt. Third, while Germany has been making nice noises lately about doing anything to save the euro and the ECB, a good deal of this was said as Germans prepared for Christmas and debated the idiocy of the World Cup playing in Qatar in 2022. Germany has a relatively new constitutional amendment that hits in a few years – I believe 2016 – and prohibits the government from running a deficit less than a fraction of one percent of GDP. After that there will be no German euros for support of bondholders, banks, or any other country. Bottom line: there is enough in the kitty to bail out Portugal, but not Spain or problems in Greece when they re-surface later in the year.
Does this all matter to traders here, there, or anywhere? Oh yes, it matters a great deal.
Again, some back-story. First, this is the crisis the ECB and The Fed are going to let grow to put pressure on political leaders for more support – and fail - and on the banking industry to clean house, clean the books and raise capital at any cost. The central bankers, after they do not get explicit support from governments, now can say they have the political backing to turn the screws on the banks and bondholders howling about sovereign debt problems. Second, Bernanke has made it clear he will do whatever it takes over here, and quietly help over there, but he also wants to take a stand and accelerate the healing of US banks.
Using 2007 accounting standards, suspended, not changed, the US banking system is arguably insolvent depending on the most recent appraisals of homes and buildings they hold mortgages on. These banks have been inflating profits by keeping loan loss reserves at a minimum but have not used this window to raise capital. And they need it, there is another half trillion in bad mortgage debt yet to be written down (my low end estimate) and hundreds of billions of commercial real estate debt to be rolled over with losses included in the rollover. A good but manageable European crisis will communicate to the banks that we will save the system, not you. Third, even Bernanke cannot ease enough to inflate equity markets against a selloff triggered by a European debt crisis. He will have to concentrate on the financial system and let equities move where they may.
Bottom line: Bernanke will not let the European crisis spill over into the US but will not intervene in a major way and if equity markets do not like the crisis they will not be there to help.
Will US equity markets react negatively to a European crisis? Yes, in three ways.
First, the dollar, precious metals and commodities triangle that has dominated trading during the entire rally and is built on quantitative easing is already unraveling and will end. What will happen is pretty simple – the dollar will go up; commodity prices will fall as the dollar strengthens; precious metals, the yen and the pound will rise as short term alternatives to the euro; and equity markets built on super cheap and weak dollars will lose steam if not fall.
Second, the first crisis a la Bear Stearns – not Lehman, the ECB will not let a big bank fail outright, it will “re-structure” the bank - will hit some bank and banks will sell off around the world, including the US. Bond yields will soar and governments will pledge more austerity. Then the prognosticators come in and start talking about the mess in Europe they have studied for six minutes and predict a European recession. European and US equity markets take a hit as this reality sinks in.
Third, facts on the ground catch up with the lack of lending, government austerity and economic malaise and the double dip hits Europe. Our own double dip, which will begin in the second half due to the dead housing market and a pullback on government stimulus, merges with theirs.
Bottom line: if the market trades a year from now based on liquidity, it may not decline too much if at all. If it responds to profits and economic reality, there are long term puts – 2012 and 2013 - on many big names.