It's time investors start asking the right questions. To date, most have focused on if European troubles will spread to the United States. The question investors should be asking instead is how sick will the U.S. get from the euro virus.
For months the Libor OIS spread, which measures the riskiness of lending between banks, has told investors to stand aside equities. Despite fits and starts in the equity markets, the measure has marched steadily higher. Today, the spread is 46 basis points, up from the teens in August and the mid 30s in November.
Similarly, the TED spread, another common measure of interbank risk because it shows the difference lenders demand above Treasuries, is similarly making new 52-week highs. Banks aren't lending to one another for a reason. They know where the bodies are buried and who buried them.
This has dire consequences which world economies are just starting to see. Recession or anemic growth has been strangling the first failed Sovereigns - Iceland, Ireland and Greece - for over three years. Despite the average American's incorrect belief the EU economy is irrelevant, Europe's economy is tectonic. If the world shudders when America drops to its knees, it similarly shakes when Europe falls.
The Fed would seem to agree. In its policy statement this week it took inflation off the table. Inflating prices were being driven by higher commodity costs. But that is a story from the first half of 2011, not the second half. Since June, commodities have broadly declined, in the process relieving the pressure valve of rising prices.
Commodity prices weakened further following MF Global's failure. The destruction of confidence to the tune of a billion plus in lost investing dollars, formerly leveraged mightily in the futures markets, can't be understated. Behind closed doors, professionals are de-risking.
The European banks haven't been the only players to be taking chips off the table. Banks who were comfortable lending anywhere for everything now lend in only some places for a few things. Most big banks remain systematically dangerous, sitting on billions of assets of declining value. Even the sovereign debt supposedly insulated is mired with uncertainty. As banks rein in balance sheets, there's little incentive to buy debt which may fall further in value and force additional capital raises. This prompted the global coordinated dollar funding changes two weeks ago and a flurry of measures out of the ECB last week - neither of which cures the buyer's strike problem.
Sovereign debt yields in Italy fell below 6% two weeks ago only to bounce back sharply. Wednesday's Italy 5-year bond auction proved a failure, given Italy had to pay the highest rate in its eurozone history to move the paper. Similarly, improvements in Hungary, which stands as a proxy for Eastern Europe funding risk, have moved back above 9%. Banks worldwide have little interest in lending to Europe and European banks have even less interest in lending to each other.
Germany has been viewed as the savior of the euro. But, the same reasons Germany can prove a savior is why it's so risky. Germany provided much of the capital overspent throughout Europe and America over the past decade. It's banks are levered at least 30 times capital. Yet, investors continue to flock to the country's bonds. Today, Germany issued 2 years at record low rates. The EU is heading further into recession and Germany is unlikely to escape unscathed, yet investors seem Pollyanna. Investors would be better served stepping away from, rather than embracing Germany. Only when Germany's own yields rise will they take steps to cure other ills.
So far, the medicine prescribed is austerity. But austerity carries its own risk. America rebooted growth, albeit anemic, not by cutting spending. Instead, it rejuvenated markets with radical spending growth. Cuts are viewed as necessary, but tax revenue won't turn up any time soon in its wake. With concern mounting that bondholders may be more unwilling to participate in the voluntary Greek haircut, where will the money come from to close the deficit gap? It's unlikely to come from further tax increases, particularly amid 20% unemployment.
Unemployment here in the States has hereto been blamed on over-regulation. Instead, it's more likely companies have kept the lid on hiring for two other reasons. First, they didn't need to hire. Why hire anyone when doing more with less has become the equivalent corporate take on consumers getting more for less? Technology has done wonders to curb job growth, which is why manufacturing capacity utilization remains below 78%, more than 2% below its long term historical average.
Secondly, major hiring comes from large multinationals who have been listening to their feet on the street overseas. What they've heard hasn't been pleasant. A shutdown in interbank lending has produced hoarding and cut off financing, much as it did here in the States. With capacity loose and decelerating demand out of the largest global economy, Europe, there has been little incentive to lift payrolls. Instead, it makes more sense to thin channel inventory.
The Fed taking inflation off the table serves as admission U.S. growth is slowing. Australia's trade deficit narrowed as commodity exports fell. China's trade balance narrowed as exports to the EU soured (remember nearly 40% of China's GDP is export driven and the EU is its biggest trading partner). And U.S. trade narrowed to its lowest this year on a bigger drop in imports than drop in exports. The U.S. Q3 GDP was revised down to 2% from prior 2.5% estimates.
All in, investors should expect the dollar (UUP) to strengthen further against the euro (FXE). Commodities, such as gold, oil and grains should be avoided until Germany's yields rise to a level suggesting a euro QE solution. This suggests shorting Germany's bonds and France's too. And, of course shorting euro region banks remains the play on rallies. Here in the U.S., non-euro exposed companies such as mid cap retailers, defensive utilities and dividend paying consumer goods make sense. It also suggests U.S. technology companies doing business overseas should be sold.