It was a tough day in major equity indices yesterday, with the S&P 500 down over 2%.
We don’t think it had much to do with the Senate’s lengthy grilling of Goldman Sachs executives. Rather, it was mostly about the continuing sovereign crisis in Europe, especially Greece and Portgual. We think it might also have been helped along by President Obama’s remarks on deficit reduction earlier in the day, though that’s a much more controversial assertion.
On top of Germany’s continuing hard line on support for Greece, S & P substantially lowered its ratings yesterday on the sovereign debt of Greece and Portgugal. Such actions lower the price that buyers are willing to pay for their debt in the market place. The resulting price adjustments are often exacerbated by rules governing institutional portfolio holdings and bank capital, as multiple large sellers head for the exits simultaneously. Momentum driven speculators might play a role as well.
In turn, lower bond prices mean higher bond yields. For example, if a bond with a $100 face value pays an annual coupon of $5, its stated yield is 5%. But if the best price the bond can fetch is $50, then the yield rises to 10%, or $5 divided by $50. The yield to maturity on such a bond is even higher, since the holder eventually receives the $100 face value at maturity.
This is trouble for Greece because a large slug of its sovereign debt matures this year, meaning that it will have to pay an exorbitantly high price (in terms of interest rates) on its new debt. If those rates are high enough that default or insolvency become inescapable, then current bond holders may not be able to recover the full face value of the bonds they own. There’s been a good deal of talk about debt restructuring, which is basically a process aimed at helping a debtor avoid a worst case outcome while containing the total damage done to creditors.
Importantly, the price adjustments did not just hit Greek and Portuguese debt, but also that of Ireland, Italy, and Spain. It’s more than a little ironic that dithering by the same governments that want banks and nations to shore up their balance sheets is having the exact opposite effect. And if that dithering continues long enough for full blown contagion effects to take hold, then the threat of the euro payments system locking up will become too large to ignore. That’s the very thing that the USD payments system faced in the wake of Lehman’s collapse and AIG’s near collapse in 2008, and which U.S. policymakers took such drastic measures to avert. Could Greece prove to be the eurozone’s Lehman, or at least its Bear Stearns? [Update 4/28/10 - We just noticed that Marshall Auerback asked a similar question on April 12th]
Ironically, Germany’s Angela Merkel has claimed that the primary motive for her country’s intransigence is to preserve the eurozone. And yet the current EMU is essentially what they’ve anted up in the high stakes game they are playing with Greece and other eurozone governments.
While we’re not huge fans of the credit rating agencies, especially given their track records during the mortgage crisis and during the twenty year bull market in Japanese government bonds, yesterday’s announcement might actually have some value when all is said and done, as long as the markets’ severe reactions act as a wake up call to European leaders. The news flow today seems to support that thesis, though only time will tell.
Meanwhile, President Obama’s remarks reminded us that the threat of premature fiscal tightening in the U.S. is still in play. We think that his call to cast a critical eye upon all federal expenditures and carefully address longer term structural deficits is absolutely appropriate (just as we think it’s fair for the German electorate to raise similar questions about Greece). However, we’re concerned that he might be a victim of the same budget surplus fetishism that has gripped many Democrats since the 1990s.
For example, he repeated, as erroneously as ever, that the federal government’s budget is like that of any family. But in fact, the federal government’s budget is more properly thought of as a complement to family and private sector budgets in the U.S. For example, if the private sector desires to increase it savings, the public sector should run larger deficits, all else equal. And if the public sector does not fully accomodate this desire, one likely result is higher private sector leverage (debt). We’re careful to point out that this dynamic is complicated by global effects — but it should still sound familiar to anyone who was awake during the past decade or two.
Amazingly, the same budget fetishists who continue to decry ”crowding out” effects in borrowing ignore those same effects when it comes to saving.
Until the President and policymakers demonstrate a better grasp of this, our call for long term USD strengthening remains on the table. And if stringent fiscal reforms are accompanied by a Fed tightening cycle, watch out. This isn’t likely to unfold until 2012-2013 (late 2011 at the earliest). However, it’s important to point out that underlying demographic cycles have the potential to make things all the worse, perhaps along the lines of a 1937 redux.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, some of the firm’s clients own shares of Alpha Bank (ALBKY), National Bank of Greece (NBG), and Currencyshares Euro Trust (FXE). One of the firm’s principals owns shares of Goldman Sachs (GS). The firm, its clients, and its principals do not hold any positions in Lehman Brothers, AIG, or the debt of any sovereign issuers mentioned.