Friday, November 5, 2010

Credit Strategy Highlights: The European sovereign debt crisis continues to impact market sentiment

The European sovereign debt 
crisis continues to impact
market sentiment

The fact that the sovereign debt crisis still has the potential to disturb risky asset markets  should not come as a surprise. Although the most immediate threats for systemic stability were mitigated by the Greek rescue package and the EFSF (and of course by austerity measures), the underlying problem will continue to smolder over a long period of time.

Investors are disturbed by two factors. First, even if structural issues can be resolved, such as cutting the primary deficit of Greece to zero (and more and more people recognize that Greece is moving to achieve this), the legacy problem (a huge debt burden) remains, and will weigh on economic growth as the cost of debt servicing contributes a significant amount to the overall deficit. Some investors argue that this situation (a balanced primary budget together with a significant legacy burden for Greece's real economy) might provide an incentive for a debt restructuring further down the road.

However, while this risk seems to be priced in already (GGBs continue to trade substantially below par), the second factor might be more important for the current performance: the risk of a self-fulfilling prophecy. Rising risk aversion might push governmental borrowing costs so high that it becomes difficult to refinance in private markets, which would argue for tapping the EFSF. Note that Irish government bond yields climbed to 7.1%, the highest level since the inception of the eurozone. Despite the argument that (German) taxpayers shouldn't bear all the costs (which
probably everybody subscribes to), politicians need to recognize that in credit markets insolvency and illiquidity are closely related. The post-Lehman developments have demonstrated forcefully how destructive a systemic bank run can be and how costly it is to stop it. You don't want this to happen in the trillion EUR sovereign debt market, as the risk is high that even the ultimate bailout-provider – Germany – lacks the financial flexibility to credibly stop such a process.

This highlights the dilemma of politicians: in order to avoid moral hazard and future credit bubbles one needs to credibly signal that private investors would have to bear default losses if they make unwise credit decisions (recall the simple truth that capitalism without losses is like religion without hell). The resulting risk awareness of investors should help to bring borrowing costs to levels that make an uneconomic debt burden unlikely (note that the fact that Greece could borrow such an amount was also driven by the fact that the funds were provided too cheaply). On the other hand, spiking risk aversion could set off the above mentioned vicious cycle of a liquidity crunch. Some investors might argue that a credit spread of several hundred bp to German Bunds should be enough of a incentive to deleverage sovereign balance sheets. Politicians would probably reply that they need to use the window of opportunity to push through necessary reforms (also to regain credibility before their voters). The tensions in this economic-political interface will probably continue to produce headline risk.

Today's data releases

As mentioned several times, this week's focus will be on the US midterm elections, the FOMC meeting and the US labor market report (the latter, however, appears to be of minor importance given that the crucial announcements regarding QE2 will come before Friday). Today, the eurozone will have PMI manufacturing releases (Italy, France, Germany and the eurozone itself).
Full report: Credit Strategy Highlights

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