Every once in a while it's nice to know that the biggest names at the world's most systemically important financial institutions know what's going on. The 2% sell-off in the S&P 500 (SPY) over the past two sessions isn't even close to enough to account for what is taking place in Europe as U.S. investors just don't seem to understand the risk they are incurring by staying in equities at what might very well be the most precarious moment for stocks since September of 2008. This sentiment was echoed by Goldman Sachs chairman Jim O'Niell (who coined the term 'BRIC') Wednesday.
O'Neill opined that the eurozone has at most two years remaining and said that, as of now, the European Monetary Union has ceased to function:
"The EMU as created doesn't work...The monetary authorities have to try something else. What is for sure (is) we cannot carry on with Spanish and Italian bond rising as they are. Not only would this represent serious challenges to EMU's existence, it would have consequences way beyond it."
Indeed. What Mr. O'Niell is implying is that if Spanish bond yields continue to rise, the country will simply have to request a troika-backed bailout, an event which would send shockwaves through markets worldwide. When evaluating the prospects for such an event, investors should consider that the credit markets seem to already be pricing in a Spanish bailout:
Spain CDS-cash basis hit record lows Tuesday. This essentially means that any marginal bid for Spanish debt that remained thanks to basis traders betting on a snap-back in the spread between bonds and credit default swaps seems to have dried-up as no one wants to hold the bonds and risk getting caught-up in the PSI where 70-80% haircuts are likely on local-law debt.
In other words, when you no longer see traders attempting to arbitrage the bond-CDS spread, you know the end is near.
Meanwhile, yields on GGB10s (Greek 10-year bonds) are now one thousand basis points higher than they were after the bond swap as the country now faces (essentially) a restructuring of the restructured debt.
For its part, Credit Suisse sees a 50% chance of a return to the drachma within 12 months. Interestingly, Credit Suisse notes that one solution to the current predicament (that Greece needs a third bailout) would be:
"...for the ECB to restructure its Greek bond holdings - on a notional flat basis into debt of a similar maturity profile to that issued under PSI for private creditors. The issue of subordination would be immediately reduced, with the ECB viewed to have ultimately had to take similar losses...as everyone else, and the (crazy) current situation whereby the euro area is providing funding to Greece to repay the ECB would go away."
There are several interesting points here. First this idea highlights the absurd circular nature of the whole situation in Europe: by taking a 75% haircut during the previous Greek bond swap, eurozone holders of Greek debt essentially provided the country breathing room so it could pay back the ECB which took no losses on its own Greek debt.
Second, one can see how safeguards built into previous bailouts are being gradually taken out as the eurozone plunges deeper and deeper into the crisis. The ECB's balance sheet is already inundated with risky Spanish and Italian debt and other poor quality pledged collateral. If it writes-down its Greek debt by 75%, that problem is compounded, not to mention the fact that the move would set a dangerous precedent as the central bank would invariably be expected to take similar losses in the event of a PSI in Spain or Italy. This may be intentional (either that or a sort-of happy coincidence) as one impediment to instituting a Spanish debt restructuring would be the bad taste left in the mouth of the private sector from the ECB's refusal to take a loss during the Greek PSI.
In any case, the situation has become so convoluted in Europe that it is difficult to see how it can ever extricate itself. Making matters worse, the prolonged nature of the crisis has caused capital to flow steadily (as opposed to all at once) into safe haven assets making them even more inflated than would have been had there been a sudden flight to safety. As a result, German bunds are grossly overvalued as noted by Carl Weinberg, chief economist at High Frequency Economics:
"the long end of the German Bund yield curve is the most dangerous place in the world...[as] Bunds are wickedly overpriced...[as fair value is] inflation plus 220 basis points."
By that math, 10-year bunds are overvalued by around 250bps, or, 2.5%.
Similarly, U.S. Treasury bonds are at record low yields, money markets have been crushed by low rates, and the yield on other safe haven debt has turned negative (at least at the shorter-end of the curve) leaving investors few options as far as what vehicles provide an acceptable mix of capital preservation and yield.
All this leads one to believe that quite literally the only option may be to either be short virtually everything including the S&P 500, U.S. Treasury bonds (TLT), German bunds, European stocks (FEZ), etc, and go long gold (GLD) and U.K. law Spanish bonds.