Jumat, 20 Juli 2012

Eurozone update: it's not as bad as many think

With markets swooning yet again over eurozone fears, it's time to revisit spreads and yields for a look at just how likely a default or disaster is likely to be, according to market pricing. As should be apparent, the fears are much worse than the facts.

First, a look at 2-yr sovereign yields, which are a decent barometer for the likelihood of a near-term default. What stands out in this chart is how much things have improved in Portugal and Ireland. It was almost exactly one year ago that yields on Irish and Portuguese debt exploded skywards. Since then they have settled back down quite a bit, with Ireland now trading through Spain and approaching Italy. Who would have thought there could be such a dramatic change in Ireland's fortunes? (It helps that Ireland has been serious about reining in government spending while keeping tax rates as low as possible.) Portugal was thought to be a basket case sure to follow in Greece's footsteps, but Portuguese debt spreads now trade within the realm of high-yield corporate debt: 5-yr Portuguese CDS spreads are about 800, with the average high-yield spread being 580.

Another thing to focus on is the amount of outstanding debt in each of these countries. At $900 billion, Spain's debt is a serious chunk of change. Spanish debt is trading between 70 and 90 cents on the dollar, so the market has already priced in something like a 20% default. If Spain goes all the way over the cliff, its debt might suffer a 70% haircut in a worst case scenario (Greek debt has suffered a loss of about 85%), which would mean wiping out an additional $450 billion of debt. But: would that be enough to bring on the end of the world as we know it? Considering that there is something like $50 trillion of debt in the world, so even a disastrous Spanish default would be only a drop in the bucket.

And as I argued a year ago, the money that the Spanish government borrowed was long ago wasted. Whether the government ends up defaulting on its debt or not, serious losses have already been incurred because the money was effectively squandered. In a true economic sense, the losses are water under the bridge. All that remains to be seen is who will be stuck with writing off the losses on their balance sheet. So the angst over potential debt defaults is overdone, and the reality of a default is likely to be much less awful than most people imagine.

Eurozone 2-yr swap spreads are now back to where they were about a year ago, and down significantly from the highs of late last year. This represents a substantial improvement in the health of the Eurozone financial markets and banks' liquidity. This is not at all consistent with fears that a Spanish default could bring down the eurozone banking industry. Moreover, euro basis swap spreads are closing in on relatively healthy territory, suggesting that Eurozone banks have reasonably good access to dollar liquidity. Spreads are still elevated, to be sure, but nothing here is even close to suggesting a near-term collapse. Meanwhile, U.S. swap spreads remain low, with financial markets in the U.S. clearly avoiding any Eurozone contagion.

Finally, although the euro has been falling in the past year, it is hardly a catastrophic decline. As the first chart shows, the euro is now equal to its average against the dollar since the euro's inception. And according to my estimate of purchasing power parity, the euro is still somewhat overvalued against the dollar. This is not what you would expect to see if the eurozone were on the verge of disaster.

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