Jumat, 18 Mei 2012

Eurozone update

It's time to look once again at the key indicators of risk in the Eurozone, especially since Eurozone fears are at the epicenter of the fears roiling world markets these days.

First, however, let's check in on the status of fears in the U.S. As the above chart shows, bond yields have fallen back to the levels they hit in late September, when the Eurozone crisis was heating up and there was lots of talk about an imminent U.S. recession. (10-yr Treasury yields hit a new all-time low of 1.7% yesterday.) I interpret this to be the result of a scramble by investors around the world to get into the safest asset that still has a measurable yield, and that sort of demand can only be driven by deep-seated fears of an extended global recession likely triggered by a Eurozone financial implosion. But: although the S&P 500 has taken a hit, it is still almost 20% above its Oct. 3rd low. Why haven't stocks tracked bonds? That's easy: earnings have continued to surprise on the upside, and the U.S. economy has shown no sign of the expected double-dip recession. Equity investors here are rattled, but they aren't nearly as fearful as global bond investors; equities have gotten a lot cheaper relative to Treasuries. Treasuries have never been more expensive. Never. I should also note that the Euro Stoxx index is now very close to its recession-era lows. Add this all up and it says that the biggest economic risks are still relatively isolated, and they can be found mainly in the Eurozone.

According to swap spreads, systemic risk in the U.S. is up a bit, but not nearly as much as in the Eurozone. There is fear of Eurozone contagion, but it's not intense by any means. Interestingly, Eurozone swap spreads are lower today than they were at the peak of the last Eurozone crisis late last year. So swap spreads are saying things are not critical at all in the U.S., and not yet catastrophic in the Eurozone. Yet 10-yr bond yields reflect an extreme degree of concern. The world's demand for Treasuries is exceptionally strong, and seems out of line with other indicators of risk.

The charts above compare 2-yr yields in various Eurozone countries. Both charts make it clear that near-term default risk in the Eurozone has declined dramatically from what it was at the end of last year. Note how the outlook for France has barely budged; the recent elections were not a surprise and the market feels moderately comfortable with near-term prospects there.

On a longer-term horizon, this chart of 5-yr CDS spreads shows that default risk in most Eurozone countries is elevated, but nevertheless equal to or lower than the default risk of the average high-yield corporate bond issuer in the U.S. (high-yield CDS spreads currently average about 700 bps). That's bad considering we're talking about the sovereign debt of developed countries, but from a global perspective it's not exactly the end of the world. Markets can live very comfortably with high-yield debt risk.

This chart helps sum things up. Europe is really struggling, but the U.S. equity market has suffered what appears to be just a correction. So far there are no signs that the U.S. economy has been dealt anything more than a glancing blow by all the turmoil in Europe. And despite all the hand-wringing and the flight to Treasuries and the Eurozone bank runs, key indicators of risk are saying that the fundamentals are not catastrophically bad by any means. I think there's a good chance the world will survive the Eurozone crisis.

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