Markets Call EU's Bluff: Sliding Closer Toward the Abyss, And Implications

by: Cliff Wachtel

Dire Implications of Latest German Backtracking

Yes, there will be those thinking, “here goes Wachtel again with his fear mongering.”

I answer that I remember when the subprime crisis was widely believed to be a limited, containable problem. Then we learned about contagion. Yeah, I get a bit more easily spooked these days. So should you. So much of how the market trends is based on sentiment, and that can build a momentum of its own that can be hard to stop, especially when that sentiment is fear.

Here We Go Again

For what must by now be at least the third time, hope is turning to despair for Greece (and probably all the PIIGS block and similarly weak economies), as yet another supposed Greek aid ‘agreement’ is revealed to be something less.

Today it was reported that both Swiss and German economic institutes are claiming the EU/IMF Greek aid plan is in violation of the Maastricht treaty, and are preparing to challenge the deal in court. There have also been voices from the German Parliament threatening legal action to stop German participation in anything that remotely smells of a German reward for Greek irresponsibility.

The likely catalyst for this latest blow up is that Greek bond sales have shown that markets continue to demand massive markups on Greek (and other PIIGS block member) bond yields to compensate for perceived risk.

This appears to effectively declare even this most recent and much improved EU/IMF plan a failure, for its entire purpose was to show such unwavering EU support for Greece that Greece would be able to borrow at rates low enough to make the plan unnecessary.

No such luck. Indeed, all the professors need to do is manage to delay the aid and they will indeed prevent it, as Greece et al slide into a death spiral of higher rates and uncontrollable deficits.

As this week’s continued high yields on Greek bonds showed, traders have grown used to EU backtracking, and had doubts that Germany was truly on board.

Those doubts are gone, and EU credibility is now on par with that of Lexus SUVs (NYSE:TM), one of which has been pulled off the market on safety concerns.

Within just the first hours of Thursday trading GMT, the euro has given back the week’s gains and looks set to test 1.3500 at least. Should that support give, there is nothing but air for support until it retests year lows around 1.3300.

Just More Negotiating- Or Passing The Point Of No Return?

Yes, this could all easily be part of the ongoing bargaining and posturing that German leaders must show their voters in order to have any chance of political survival.

Nonetheless, market confidence or fear is a very tough thing to control and contain once it builds up momentum. Unless the Germans can overcome their ambivalence in a decisively public manner, EU credibility may be so shot that the following chain of events may be irreversible:

  • Greece is unable to borrow at rates that allow it any chance of recovery.
  • EU makes another one or more attempts to calm markets, each needing to be increasingly more expensive to counteract the loss of credibility thus far. At that point either:
  1. EU successfully pulls off at least a short term rescue . As this is a form of QE, the EUR likely remains under pressure, especially because Greece is just one of a number of countries that may be coming for aid. Given the relative calm in the markets, this is clearly the assumed minimal outcome.
  2. EU at some point is shown unable to save Greece. Greece defaults, sparking a likely contagion of sovereign defaults among at least the weaker EU and global economies as they become effectively shut out of bond markets and the IMF is quickly overwhelmed.


That in turn appears to mean one of the following:

The Best-Case Scenario

Defaults and bankruptcies remain relatively contained to the poorest states and a limited number of banks and insurance companies with heavy exposure to these economies, as wealthier nations are able to provide bailouts for those banks that present systemic risk. Global markets pullback hard on sheer fear of how far the contagion risk could go, as traders sell first, ask questions later. However, as seen in late 2008, early 2009, damage would be contained to a nasty market correction and boost in safe haven assets like the USD and AAA government bonds. The ongoing global recovery suffers at least a temporary setback. Again, this is the best likely case.

The Worst-Case Scenario

Who really knows? What is clear is that a far more serious contagion spreads. If the recent past is any guide, likely effects include a global credit freeze-up until it becomes clear which banks are directly and indirectly exposed. For example, Greek banks hold lots of Greek debt, and also provide significant credit to central and eastern Europe. That credit would likely dry up.

As Reggie Middleton has repeatedly pointed out in his, there are numerous large banks in Europe that would be at risk of failing if there is a wave of PIIGS block defaults, and these banks may well be too big for their governments to save, especially those that don’t have their own printing presses, like those in the EU. That means we get a much bigger financial crisis than seen in late 2008-early 2009.

Non EU countries that can at least continue to print money could survive, or at least buy some more time. Much depends on how many of their leading banks with significant exposure to whatever dominos have fallen are able to survive or be bailed out. Frankly I don’t have the information needed to know who owes what to whom and what one major sovereign or bank default could mean elsewhere.

But neither do most market participants, and that means some panic selling ahead at very least.

EU Credibility Fading Fast

What is clear is that the EU is rapidly running out of credibility, and when that happens, the game for the EU, probably the global recovery, and possibly much more, will be truly over.

Perhaps an international solution, with more of the still-standing economies more deeply involved? Is there a choice?

For the short term: Continued downtrend in the EUR and probably currencies of the neighboring currency blocks, the GBP and CHF. Warts and all the USD and JPY go higher as the lesser evils, ditto related bonds. Longer term?

Update: As I post this, just got word that Portugal and Spain Credit Default Swaps are widening, meaning higher borrowing costs.

Disclosure: No positions