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http://www.telegraph.co.uk/finance/c...ence-ebbs.htmlWe gotta plug and think, we gotta feed it right
There ain't no danger we can go too far
We start believing now that we can be what we are
Greek Ouzo crisis escalates into global margin call as confidence ebbs
For the third time in 18 months the global financial system risks spinning out of control unless political leaders take immediate and radical action.
By Ambrose Evans-Pritchard
Published: 5:46PM GMT 07 Feb 2010
Comments 11 | Comment on this article
Flow data shows an abrupt withdrawal of German and Asian capital from Club Med debt markets. The EU's refusal to offer Greece anything beyond stern words and a one-month deadline for harsher austerity – while admirable in one sense – is to misjudge how fast confidence is ebbing. Greece's drama has already metastasised into a wider systemic crisis. The world risks a replay of the Lehman collapse if this runs unchecked, this time involving sovereign dominoes.
Barclays Capital says the net external liabilities of Greece are 87pc of GDP, or €208bn (£182bn). Spain is worse at 91pc (€950bn), and Portugal worse yet at 108pc (€177bn); Ireland is 68pc (€123bn), Italy is 23pc, (€347bn). Add East Europe's bubble and foreign debts top €2 trillion.
The scale matches America's sub-prime/Alt-A adventure and assorted CDOs and SIVS of the Greenspan fling. The parallels are closer than Europe cares to admit. Just as Benelux funds and German Landesbanken bought subprime debt for high yield with AAA gloss, they bought Spanish Cedulas because these too had a safe gloss – even though Spain's property boom broke world records. They thought EMU had eliminated risk: it merely switched exchange risk into credit risk.
A fat chunk of Club Med debt has to be rolled over soon. Capital Economics said the share of state debt maturing this year is even higher in Spain (17pc) than in Greece (12pc), though Spain's Achilles' Heel is mortgage debt.
The risk is the EMU version of Mexico's Tequila crisis or Asia's crisis in 1998. This Ouzo crisis is coming to a head just as tougher bank rules cause German lenders to restrict loans, and it touches on the most neuralgic issue of our day: that governments themselves are running low. Britain, France, Japan, and the US are all vulnerable. All must retrench. The great "reflation trade" of 2009 is over.
Far from containing the crisis, Europe's response recalls the Lehman/AIG events of 2008 when Brussels sat frozen, and Germany dragged its feet. On that occasion France took charge, in the nick of time.
Today's events will not wait. The rocketing cost of (CDS) default insurance on Iberian debt speaks for itself. Lisbon retreated from a €500m bond issue last week, even before the government lost a crucial finance vote. Can Athens raise money at all on viable terms?
There are echoes of early 2009 when East Europe blew up, with contagion hitting global bourses, commodities, and iTraxx credit indices. That episode was halted by the G20 deal to triple the IMF's fire-fighting fund to $750bn. The odd twist today is that Greece cannot turn to the IMF because that offends EMU pride, yet no other help is on offer because the EU has no fiscal authority. Greece lies prostrate between two stools.
Both the City and Brussels seem certain that Europe will conjure a rescue, crossing the Rubicon towards fiscal federalism and a debt union. The emergency aid clause of Article 122 is on everybody's lips. Insiders talk of a "Eurobond".
On balance, such a rescue is likely. Yet leaving aside whether North Europe can afford to guarantee Club Med debt – or whether a bail-out pollutes more countries, as HBOS polluted Lloyds – there is one overwhelming fact missing from the debate: Germany has not endorsed any such rescue.
Jurgen Stark, Germany's champion at the European Central Bank, said markets are "deluding themselves" if they think others will pay to save Greece. He shot down Article 122, saying Athens was responsible for its own mess.
Bundesbank chief Axel Weber said it would be "politically impossible" to ask taxpayers to bail out a profligate state. Both the finance and economy ministers have forsworn a rescue. Die Welt has called for Greek withdrawal from the euro.
I cannot judge how much is brinkmanship, pressure to make Club Med sweat. But I remember vividly lunching with the British prime minister's economic adviser in August 1992 and being told that Germany would soon rescue sterling in the Exchange Rate Mechanism by cutting rates. Such was the self-deception of the British elite. Anybody following German politics – such as George Soros– knew it was nonsense.
Germany is harder to read today. The euro is a giant step beyond the ERM. Yet there are powerful counter-currents. Germany's constitutional court issued a crushing put-down of EU pretensions last June, ruling that the sovereign states are "Masters of the Treaties" and that EU bodies lack democratic legitimacy.
So if you are betting that Germany must forever more efface itself for the European Project, be careful. Berlin hawks might prefer to lance the Club Med boil sooner rather than later.
For the third time in 18 months the global financial system risks spinning out of control unless political leaders take immediate and radical action.
By Ambrose Evans-Pritchard
Published: 5:46PM GMT 07 Feb 2010
Comments 11 | Comment on this article
Flow data shows an abrupt withdrawal of German and Asian capital from Club Med debt markets. The EU's refusal to offer Greece anything beyond stern words and a one-month deadline for harsher austerity – while admirable in one sense – is to misjudge how fast confidence is ebbing. Greece's drama has already metastasised into a wider systemic crisis. The world risks a replay of the Lehman collapse if this runs unchecked, this time involving sovereign dominoes.
Barclays Capital says the net external liabilities of Greece are 87pc of GDP, or €208bn (£182bn). Spain is worse at 91pc (€950bn), and Portugal worse yet at 108pc (€177bn); Ireland is 68pc (€123bn), Italy is 23pc, (€347bn). Add East Europe's bubble and foreign debts top €2 trillion.
The scale matches America's sub-prime/Alt-A adventure and assorted CDOs and SIVS of the Greenspan fling. The parallels are closer than Europe cares to admit. Just as Benelux funds and German Landesbanken bought subprime debt for high yield with AAA gloss, they bought Spanish Cedulas because these too had a safe gloss – even though Spain's property boom broke world records. They thought EMU had eliminated risk: it merely switched exchange risk into credit risk.
A fat chunk of Club Med debt has to be rolled over soon. Capital Economics said the share of state debt maturing this year is even higher in Spain (17pc) than in Greece (12pc), though Spain's Achilles' Heel is mortgage debt.
The risk is the EMU version of Mexico's Tequila crisis or Asia's crisis in 1998. This Ouzo crisis is coming to a head just as tougher bank rules cause German lenders to restrict loans, and it touches on the most neuralgic issue of our day: that governments themselves are running low. Britain, France, Japan, and the US are all vulnerable. All must retrench. The great "reflation trade" of 2009 is over.
Far from containing the crisis, Europe's response recalls the Lehman/AIG events of 2008 when Brussels sat frozen, and Germany dragged its feet. On that occasion France took charge, in the nick of time.
Today's events will not wait. The rocketing cost of (CDS) default insurance on Iberian debt speaks for itself. Lisbon retreated from a €500m bond issue last week, even before the government lost a crucial finance vote. Can Athens raise money at all on viable terms?
There are echoes of early 2009 when East Europe blew up, with contagion hitting global bourses, commodities, and iTraxx credit indices. That episode was halted by the G20 deal to triple the IMF's fire-fighting fund to $750bn. The odd twist today is that Greece cannot turn to the IMF because that offends EMU pride, yet no other help is on offer because the EU has no fiscal authority. Greece lies prostrate between two stools.
Both the City and Brussels seem certain that Europe will conjure a rescue, crossing the Rubicon towards fiscal federalism and a debt union. The emergency aid clause of Article 122 is on everybody's lips. Insiders talk of a "Eurobond".
On balance, such a rescue is likely. Yet leaving aside whether North Europe can afford to guarantee Club Med debt – or whether a bail-out pollutes more countries, as HBOS polluted Lloyds – there is one overwhelming fact missing from the debate: Germany has not endorsed any such rescue.
Jurgen Stark, Germany's champion at the European Central Bank, said markets are "deluding themselves" if they think others will pay to save Greece. He shot down Article 122, saying Athens was responsible for its own mess.
Bundesbank chief Axel Weber said it would be "politically impossible" to ask taxpayers to bail out a profligate state. Both the finance and economy ministers have forsworn a rescue. Die Welt has called for Greek withdrawal from the euro.
I cannot judge how much is brinkmanship, pressure to make Club Med sweat. But I remember vividly lunching with the British prime minister's economic adviser in August 1992 and being told that Germany would soon rescue sterling in the Exchange Rate Mechanism by cutting rates. Such was the self-deception of the British elite. Anybody following German politics – such as George Soros– knew it was nonsense.
Germany is harder to read today. The euro is a giant step beyond the ERM. Yet there are powerful counter-currents. Germany's constitutional court issued a crushing put-down of EU pretensions last June, ruling that the sovereign states are "Masters of the Treaties" and that EU bodies lack democratic legitimacy.
So if you are betting that Germany must forever more efface itself for the European Project, be careful. Berlin hawks might prefer to lance the Club Med boil sooner rather than later.
http://www.zerohedge.com/article/contagion
Contagion
Tyler Durden's picture
Submitted by Tyler Durden on 02/07/2010 02:22 -0500
From Foreign Exchange Research, Barclays Capital
The key lesson from the ERM crisis of 1992 and the Asian crisis of 1997 is that contagion can emerge quickly and often in unpredictable ways. Unwinding of leveraged positions by distressed market participants, herding behaviour among investors, and loss of liquidity that gives way to general flight to quality can all lead to heightened correlations between markets and, in extremely circumstances, set off a self-filling crisis on a regional/global scale. There have been clear signs over the past week that the distress in the Greek government bond market is increasingly being felt in other euro area countries such as Spain and Portugal. The most likely explanation of this development is the “demonstration effect” – the Greek crisis is likely to have caused investors to re-evaluate the fundamentals of these countries. Spain and Greece may not have strong financial or economic links, but their fundamentals have a lot in common.
The possibility of contagion of the Greek crisis may not end with Spain. There is a presumption among investors that in the worst case scenario (and we are not there yet) the EU will give Greece financial assistance. If this is an isolated event, the effect on the overall public finances of the EU is unlikely to be substantial. However, a bailout of Greece may make aid to other countries in similar situations more likely (moral hazard). A series of open-ended bailouts would not only undermine the fiscal positions of core euro area countries such as Germany and France but, more dangerously, would weaken their political commitment to the continuation of the euro area project.
This is probably why Greece is exerting what may seem to be a disproportionate influence on the markets of other euro area countries. We can see this by using the principal component analysis (PCA) to identify the common drivers of the EU government bond markets. Our exercise focuses on Germany, France, UK, Spain, Italy, Sweden and Greece. Figure 3 presents the factor weights of the first two principal components for the past six months. The first two principal components can be interpreted as latent factors capturing the majority of the variation (the r-square is a cumulative 80%) in bond yields across the various European countries. They illustrate that while Greece has been a relatively small part of the primary common driver of the major EU government bond markets, it has been the most important component of the secondary common driver.
It is often found in PCA that it is difficult to attribute a particular principal component to a specific economic driver. However, while we can probably view the first principal component as capturing the common factor for the European interest rate cycles, one interpretation of the second principle component is as a reflection of the common sovereign risk. The fact that the factor weights for the likes of Greece, Italy, and Spain carry a positive sign, while Germany, Sweden, UK and France carry negative weights, would support this interpretation. We also note that this second principal component can explain 20% of the joint variation of returns of government bond yields over the sample period.
Global dimension of sovereign crisis
If it was a mistake three months ago to view the Greek crisis as a localized event, it would be a mistake now to see it as a euro-area-specific event. Indeed, global sovereign risk premia, which declined steadily in the first half of 2009, have been all moving higher at varying speeds since last September (Figure 4).
Sovereign CDS has a short history. To get a sense of where sovereign credit risk premium is now relative to history, we need to find alternative measures. One such proxy is swap spreads (differential between the fixed rate leg of interest rate swaps and government bond yields). While the usual interpretation of very wide positive swap spreads is heightened counterparty risks and flight to quality, the natural interpretation of very narrow positive swap spreads (or wide negative spreads) is that it reflects high sovereign credit and refinancing risk premium. Figure 6 plots the average 10y swap spreads for the 10 largest developed economies in the world (US, Japan, Germany, France, UK, Italy, Spain, Canada Australia and Sweden). It demonstrates that the level of the spread is currently a two standard deviations event relative to the past twenty years. In this sense, it may not be an exaggeration to say that general developed country sovereign risk premium is at a 20-year high.
The same chart shows that swap spreads were negative back in January 2009 when the market had to digest the news of President Obama’s $787bn stimulus program but these concerns eased through most of 2009. Can that happen again? We would argue that the easing of sovereign risk is due in large part to the Fed’s large-scale asset purchase program, which we have argued in the past (The case for a stronger USD in 2010, 27 November 2009) extensively created a bond shortage (Figure 5). With the BoE deciding to pause in its asset purchase program this week and our view that the Fed will follow suit in March, the bond market will struggle to digest the record sovereign issuance in the pipeline globally this year. This means that all else being equal, sovereign credit risk premium can remain at the current elevated levels or even rise further. From this point of view, the risk is that yield curves could continue to steepen, inflation breakevens expand (Figure 7), and swaption vols rise again (Figure 8).
Implications of sovereign credit risk crisis
* Increased general sovereign credit risk premium will have obvious market implications:It is clearly negative for cyclical and risky assets. Over the past year, the markets have become used to the idea that policymakers are not only all willing but they are also all powerful when it comes to crisis response. In so far as higher sovereign credit risk premium will constrain the ability of the policymakers to respond aggressively to future crisis via fiscal policy, at a minimum this calls into question the assertion that they remain all powerful. Higher sovereign risk premium also implies that crowding-out effects associated with more expansionary fiscal policy will be greater.
* Increased sovereign credit risk premium can lead to flight to quality where more-liquid government bond markets and countries with stronger fiscal positions will benefit at theexpense of less-liquid markets with weaker fiscal positions. The USD will benefit from the relative liquidity of the US Treasury markets. In addition, as we have been arguing since December, the USD will also benefit from the relative improvement of the US fiscal position in 2010.
* The JPY has had few friends over the past few months as investors have focused on Japan’s deteriorating fiscal story and its high debt overhang. This is why short JPY positions were very popular until the past few weeks. What would be the effect of a general increase in sovereign risk premium for the JPY? We believe such a development may turn out to be ironically JPY positive. This is because of Japan’s low dependence on foreign financing. One way to see this is by comparing JGB yields with Treasury and Bund yields, but adjusting for currency risk. By this measure, we find that both US and German sovereign risk premia have increased relative to that of Japan over the past year and their relative risk premia are near their highs of the past 10 years. Thus, it is not that the market is not paying enough attention to Japan’s fiscal challenge, but it appears that US and Germany’s fiscal problems have brought them much closer to Japan.
Tyler Durden's picture
Submitted by Tyler Durden on 02/07/2010 02:22 -0500
From Foreign Exchange Research, Barclays Capital
The key lesson from the ERM crisis of 1992 and the Asian crisis of 1997 is that contagion can emerge quickly and often in unpredictable ways. Unwinding of leveraged positions by distressed market participants, herding behaviour among investors, and loss of liquidity that gives way to general flight to quality can all lead to heightened correlations between markets and, in extremely circumstances, set off a self-filling crisis on a regional/global scale. There have been clear signs over the past week that the distress in the Greek government bond market is increasingly being felt in other euro area countries such as Spain and Portugal. The most likely explanation of this development is the “demonstration effect” – the Greek crisis is likely to have caused investors to re-evaluate the fundamentals of these countries. Spain and Greece may not have strong financial or economic links, but their fundamentals have a lot in common.
The possibility of contagion of the Greek crisis may not end with Spain. There is a presumption among investors that in the worst case scenario (and we are not there yet) the EU will give Greece financial assistance. If this is an isolated event, the effect on the overall public finances of the EU is unlikely to be substantial. However, a bailout of Greece may make aid to other countries in similar situations more likely (moral hazard). A series of open-ended bailouts would not only undermine the fiscal positions of core euro area countries such as Germany and France but, more dangerously, would weaken their political commitment to the continuation of the euro area project.
This is probably why Greece is exerting what may seem to be a disproportionate influence on the markets of other euro area countries. We can see this by using the principal component analysis (PCA) to identify the common drivers of the EU government bond markets. Our exercise focuses on Germany, France, UK, Spain, Italy, Sweden and Greece. Figure 3 presents the factor weights of the first two principal components for the past six months. The first two principal components can be interpreted as latent factors capturing the majority of the variation (the r-square is a cumulative 80%) in bond yields across the various European countries. They illustrate that while Greece has been a relatively small part of the primary common driver of the major EU government bond markets, it has been the most important component of the secondary common driver.
It is often found in PCA that it is difficult to attribute a particular principal component to a specific economic driver. However, while we can probably view the first principal component as capturing the common factor for the European interest rate cycles, one interpretation of the second principle component is as a reflection of the common sovereign risk. The fact that the factor weights for the likes of Greece, Italy, and Spain carry a positive sign, while Germany, Sweden, UK and France carry negative weights, would support this interpretation. We also note that this second principal component can explain 20% of the joint variation of returns of government bond yields over the sample period.
Global dimension of sovereign crisis
If it was a mistake three months ago to view the Greek crisis as a localized event, it would be a mistake now to see it as a euro-area-specific event. Indeed, global sovereign risk premia, which declined steadily in the first half of 2009, have been all moving higher at varying speeds since last September (Figure 4).
Sovereign CDS has a short history. To get a sense of where sovereign credit risk premium is now relative to history, we need to find alternative measures. One such proxy is swap spreads (differential between the fixed rate leg of interest rate swaps and government bond yields). While the usual interpretation of very wide positive swap spreads is heightened counterparty risks and flight to quality, the natural interpretation of very narrow positive swap spreads (or wide negative spreads) is that it reflects high sovereign credit and refinancing risk premium. Figure 6 plots the average 10y swap spreads for the 10 largest developed economies in the world (US, Japan, Germany, France, UK, Italy, Spain, Canada Australia and Sweden). It demonstrates that the level of the spread is currently a two standard deviations event relative to the past twenty years. In this sense, it may not be an exaggeration to say that general developed country sovereign risk premium is at a 20-year high.
The same chart shows that swap spreads were negative back in January 2009 when the market had to digest the news of President Obama’s $787bn stimulus program but these concerns eased through most of 2009. Can that happen again? We would argue that the easing of sovereign risk is due in large part to the Fed’s large-scale asset purchase program, which we have argued in the past (The case for a stronger USD in 2010, 27 November 2009) extensively created a bond shortage (Figure 5). With the BoE deciding to pause in its asset purchase program this week and our view that the Fed will follow suit in March, the bond market will struggle to digest the record sovereign issuance in the pipeline globally this year. This means that all else being equal, sovereign credit risk premium can remain at the current elevated levels or even rise further. From this point of view, the risk is that yield curves could continue to steepen, inflation breakevens expand (Figure 7), and swaption vols rise again (Figure 8).
Implications of sovereign credit risk crisis
* Increased general sovereign credit risk premium will have obvious market implications:It is clearly negative for cyclical and risky assets. Over the past year, the markets have become used to the idea that policymakers are not only all willing but they are also all powerful when it comes to crisis response. In so far as higher sovereign credit risk premium will constrain the ability of the policymakers to respond aggressively to future crisis via fiscal policy, at a minimum this calls into question the assertion that they remain all powerful. Higher sovereign risk premium also implies that crowding-out effects associated with more expansionary fiscal policy will be greater.
* Increased sovereign credit risk premium can lead to flight to quality where more-liquid government bond markets and countries with stronger fiscal positions will benefit at theexpense of less-liquid markets with weaker fiscal positions. The USD will benefit from the relative liquidity of the US Treasury markets. In addition, as we have been arguing since December, the USD will also benefit from the relative improvement of the US fiscal position in 2010.
* The JPY has had few friends over the past few months as investors have focused on Japan’s deteriorating fiscal story and its high debt overhang. This is why short JPY positions were very popular until the past few weeks. What would be the effect of a general increase in sovereign risk premium for the JPY? We believe such a development may turn out to be ironically JPY positive. This is because of Japan’s low dependence on foreign financing. One way to see this is by comparing JGB yields with Treasury and Bund yields, but adjusting for currency risk. By this measure, we find that both US and German sovereign risk premia have increased relative to that of Japan over the past year and their relative risk premia are near their highs of the past 10 years. Thus, it is not that the market is not paying enough attention to Japan’s fiscal challenge, but it appears that US and Germany’s fiscal problems have brought them much closer to Japan.
Comment