Keeping One Eye On The PIIGS

By now we should all know the story about PIIGS, so I will spare you the introductions other than say one phrase: debt contagion. If you are smart enough, you probably figured this out back in late 2009, but if you haven't then just have a look at the picture above. Therefore, lets move on from the obvious reasons of why Eurozone is trouble towards when the debt crisis problem could really spark an event. In the markets, certain things are obvious, but that doesn't mean that they are about to occur tomorrow or two weeks from now. In other words, timing is everything.

With that in mind, I thought I put forward recent developments in the Eurozone Debt & Credit markets, due to various alarm bells ringing last week.

We all know Greece is bust. I could just end the post here and it would make a lot of sense to everyone without a question. However, up until today the EU has refused to let Greece default on its debt and bond holders to take a haircut. With debt so interlinked through Europe, this event could and possibly would trigger our key phrase mentioned above: debt contagion.

The spread between Greek and German bonds remains extremely elevated, as investors dump Greek bonds and rush into German Bunds. Greek 10 Year Yield, which is currently sitting at 17.6%, is flashing warning signals that there is a very large possibility of a Greek default, but its just a matter of when?

If we look at the credit market, then we could gain some form of an answer. Greek Credit Default Swaps (CDS), an insurance mechanism used for protection against sovereign default, has pretty much gone parabolic since early April. The Greek CDS market is in panic, that is for sure!

Now, some investors would say, Greek default has been talked about for months and months, actually years now. They would argue that this is priced in, at least to some degree. While I could agree to a certain extent, this posts focus is on debt contagion, so therefore I would argue that while Greek bond haircut might be priced in... to a degree, a total spiral of defaults across Europe is definitely not.

I don't want to scare you here, my fellow reader, so do not misunderstand me. I am not saying that this event will happen, because one should not underestimate European politic will power to kick the can down the road until 201x year. However, I do want to place this possibly on a radar because even if it does not happen, the market itself could overreact and turn into a panic that spreads like a wild Australian bush fire.

Spread where you might ask?

Ireland and Portugal is the first and most obvious answer. The spread between Irish and Portugal's 10 Year Yield against German 10 Year Bund is currently sitting at 11.3% and 10% respectively. Not a mild risk, is it? And it seems that majority of the panic selling in these two countries Bonds is occurred just recently. The short squeezes (also known as pullbacks) seems to be getting smaller and smaller. Yields are rising in a parabolic fashion here as well.

If we look at the credit market here as well, the story is following Greek CDS blueprint. The vertical panic rise in both Irish and Portugal's CDS makes me think that there is a decent possibility of something awful happening just around the corner. Media is running stories around in circles of how Greek and Portuguese debt has been downgraded to "Junk" (thanks Moody's - as if we didn't already know this years ago), while rumours are spreading of Ireland needing another bailout... come on guys, its been ages since the last bail out in December!

Greek default is one thing, while Greek, Portugal's and Irish default at once is a completely different thing all together. This is known as debt contagion. Obviously, European Stability Fund and its political generals will not allow for this to occur, at least not right now. So the fears could be overblown and investors could be overly pessimistic on the Eurozone area once again.

We saw all of this before... remember June 2010 when EU was about to split up? And remember January 2011 when Ireland was about to leave the EU? Both events resulted in huge short squeezes against speculators betting against the Eurozone Crisis. So yeah, one could say the fears could be overblown... until last weeks events in Italy and Spain.

Bang! Just like that, Spanish and Italian 10 Year Yield surged vertically. Spreads between these interest rates and German Bunds blew out to over 3% in both case. While this might not seem extreme when compared to spreads on the other PIIGS featured above, bond vigilantes would nonetheless yell out: debt contagion in progress. Besides, Italian debt is bigger than the rest of the PIGS put together. At one point in time Italian rates were above 6% and Spain was reaching levels where Portugal was only months ago. It seems that the shit is really starting to hit the fan, excuse for the language.

Also to note is that Italian CDS closed at all time new highs. The Global Financial Crisis of 2008/09 is now starting to look like a walk in the park for both Span and Italy. The real test is either here or coming up real soon.

Both the Euro Dollar exchange rate, as well as the Eurozone 50 equities index are flirting with major supports, which if breached, could spell more downside. Keep in mind that with high volatility in progress, false break downs also known as "bear traps" are very common during these periods. Last week we already experienced that once in both EUR/USD below $1.40 and in Euro 50 below 2,600.

I do have to admit that 2008 fears are in the back of all of our minds. And that is precisely the problem I have with all this. Even though I do not doubt for one second the whole of Europe could turn into a massive Australian bush fire by tonights market open, in the same time I get this feeling that things are just a little to obvious right now. Now, obviously I could be very very wrong here, but consider the following:

U.S. Stocks May Slide 24% as Recession Looms, GMI’s Pal Says

July 15 (Bloomberg) -- The Standard & Poor’s 500 Index may fall as much as 24 percent and the euro might tumble to $1.20 if the U.S. economy slows further and Europe’s debt crisis widens, said Raoul Pal, the former GLG Partners Inc. fund manager currently writing the Global Macro Investor strategy sheet.

“I think with the European situation seemingly unresolvable, it’s likely we will see accelerated downside in the latter part of the summer,” Pal, who also worked in hedge- fund sales for Goldman Sachs Group Inc. and predicted the financial meltdown of 2008, said in a phone interview from Javea, Spain. “It does all depend on the U.S. economic data, but the highest possibility for me is we are going into a recession.”

Writing in the July edition of GMI, published July 1 and updated this week, Pal said the current situation resembles the conditions in early 2008, when the Institute for Supply Management’s U.S. manufacturing gauge was at 51.1, before it collapsed to 33.3 by the end of that year.

The S&P 500 may reach 1,000 by the end of 2011, Pal said, though the index has a support level about 1,250, which technical analysts who follow charts say can act as a floor limiting losses. If economic reports improve, equities may rebound as they did last summer, he said.

The euro may fall to $1.20 from $1.41 yesterday as the region’s debt crisis worsens, Pal wrote this week, citing technical analysis charts. The move will be followed by a bounce, and the currency will then “finally roll over and head well below parity,” he wrote. He said he’s bullish on the dollar and Treasuries.

“Deficit reduction in a slowing economy is next to impossible,” Pal wrote. “This is a real vicious circle. Delaying an eventual default is actually making things in Greece much, much worse.”

Problems facing the banking system and real-estate market in Europe are particularly noticeable on Spain’s Mediterranean coast, where he lives, the strategist said. “The property market is still awful,” Pal said. “Properties are being sold at a 40 to 50 percent discount. Apartments don’t sell at all, at any price.”

“Spain is Lehman Brothers, whilst Greece is Bear Stearns,” Pal wrote in the report. “Once Spain goes I think we will be heading into the vortex of multiple sovereign defaults,” he wrote.

It seems that perma-bearish deflationists, who have been calling for the end of the world the whole way up from March 2009 lows, are constantly in love with phrases like "This and that resembles 2008" and "Lehman Brothers this, Bear Sterns that". Now, consider the next article:

Forint, Zloty Most Vulnerable in a ‘Lehman II,’ Citigroup Says

July 15 (Bloomberg) -- Hungary’s forint, Poland’s zloty, South Africa’s rand and Brazil’s real are the emerging-market currencies most vulnerable to credit crisis, like that sparked by Lehman Brothers Holdings Inc.’s collapse, from the European Union’s fiscal problems, according to Citigroup Inc.

“The European crisis is at a critical point” in which either its leaders come “up with a shock and awe package or the situation deteriorates significantly,” analysts at Citigroup led by Monty Gandhi wrote in a research report dated July 14. “If it became more certain that the EU is not going to act in a more pro-active way, we would expect most currencies to sell off, but would expect” the zloty, forint, rand and real “to perform the worst.”

Citigroup measured vulnerability by taking foreign-exchange reserves divided by the sum of the current-account deficit and debt maturing in one year. It also analyzed net monthly long positions, or market bets that a currency will strengthen. Foreign-currency flows into the bonds of Poland, Hungary and South Africa were still the “major catalysts” behind the positioning in the zloty, forint and rand, the note said. In Latin America, the highest positioning is in the real followed by the Mexican peso, according to the report.

Well, if we were to follow a mad dog investor like Raoul Pal, we would have to also side with Citigroup. They too are saying that the current problems feel "like that sparked by Lehman Brothers in 2008". They have their own nickname to it - Lehman II. Consider the next article:

SocGen, UBS Say Buy Protection Against Euro Breakup Scenario

July 15 (Bloomberg) -- Societe Generale SA recommended buying insurance against a euro “meltdown,” and UBS AG said the Danish krone may offer protection as Europe’s debt crisis threatens to deteriorate.

“It is not too late to get hedges,” SocGen strategists David Deddouche and Olivier Korber wrote in an investor report dated yesterday. “We simply cannot rule out entirely a further dramatic collapse” of the euro against the dollar, and a rebound in the 17-nation currency to above $1.40 “provides a fresh opportunity to hedge against such an event through tail options,” they said.

UBS currency strategist Chris Walker said “a significant escalation in the euro-zone debt crisis, to the extent the existence of the euro is itself threatened, could lead to the abandonment” of Denmark’s currency peg to the euro. Though this would cause short-term volatility, longer term the krone would likely appreciate against other Scandinavian currencies and the euro, he wrote.

Well, it wasn't long before the "EU Break Up" bears came out once again. And just like before, they are once again siding with the US Dollar and against the Euro. Have these people lost their minds? Even if the Euro does collapse, I am pretty sure it would still hold its own against the confetti paper, like King Dollar. Consider the next article:

Traders See 41% Chance of Lehman-Style Cut: Australia Credit

July 15 (Bloomberg) -- Traders are adding to bets Australia’s central bank will repeat its emergency interest-rate cuts of 2008 as the economy falters and concern intensifies that U.S. and European debt burdens will derail global growth.

The yield on December cash-rate futures was 4.345 percent as of 4:45 p.m. in Sydney. That implies the Reserve Bank of Australia will lower its benchmark of 4.75 percent to 4.5 percent by year-end, and a 41 percent chance of a reduction to 3.75 percent. Ten-year government bond yields fell the most this week since since December 2008.

Stevens slashed the cash rate to 3 percent from 7.25 percent between September 2008 and April 2009, in a record stretch, to counter a global credit freeze. The RBA’s post- Lehman reaction included three rate cuts of 100 basis points each, the first time the central bank had moved by more than 25 basis points at a time since 2001.

Australia’s 10-year yield fell as low as 4.90 percent today, the least since Sept. 8, from this year’s high of 5.84 percent on Feb. 8. It dropped 32 basis points, or 0.32 percentage point, this week to 4.91 percent as of 4:59 p.m. in Sydney, or 2 percentage points more than similar-maturity Treasuries.

Two-year Australian yields fell to 4.33 percent, down 41 basis points since June 30, and are set for a third monthly drop.

“The move to lower yields at the front of the curve has been the real pain trade and a lot of people have lost a lot of money,” said Auld. “That means the appetite to put on any risk is very minimal, especially in a world where you really don’t know what’s going to happen one day to the next in Europe.”

Lehman Style, post-Lehamn reaction, Lehman II, Spain is Lehman... do you guys notice a trend here? As Hugh Hendry famously said once... these guys keeping coming on TV, and they keep saying the same thing.

Am I just imaging things or are these humans once again engaging in their favourite activity - herding? It sounds to me like everyone is thinking the same thing along the lines of Lehman No. 2 event. And we all know what they say about those herders:

"If Everyone Is Thinking The Same Thing, Then No One Is Thinking" ~ George S. Patton

I do not own a crystal ball, nor am I good enough to tell you if there is going to be a debt default within the next few days/weeks. There are some very serious risks out there, that is for sure. And the equity markets in the US are almost 100% from their March 2009 lows. We are eventually due for a bear market and it is not about why, just a matter of when as stated above. (For those wondering why, the answer is because US equities are in a secular bear market)

However, having said that, a lot of market participants are expecting a Lehman style event right here, right now. We do have one advantage in the market place and that is being contrarian. It doesn't always work, but as a famous investor once said - you're either a contrarian or a victim. The choice is yours!

p.s. I must have said debt contagion about a trillion times. Just as much as EU will need in bail outs.