Investors brace for dramatic new stage in Europe
MADRID (MarketWatch) -- Investors have begun preparing for a dramatic new stage in the European debt crisis ahead of a weekend Greek vote that could help determine the future of the euro zone.
In a sign of the heightened tension, global markets were boosted late in the week on reports that central bankers stand ready to act in the case of a credit crunch following the Greek elections.
Edward Hugh, an independent economist and well-known blogger based in Barcelona, said investors are beginning to make calls as to whether the euro will disintegrate or ultimately be saved. "I think investors are trying to cover themselves both ways," said Hugh. "If you buy German [credit-default swaps], it's win-win."
A CDS is a financial swap agreement under which the buyer is compensated by the seller in the event of a default or another credit event. The cost of insuring against a German government default has risen since the beginning of the year. Data from Markit show German 5-year CDS spreads have been widening since April as the euro-zone crisis has heated up.
By buying German CDSs, Hugh said, investors protect against an incapacity of one or more of Europe's sovereign nations to repay debt. And alongside fears that sovereign nations will be unable to repay debt are fears that the currency union itself could eventually collapse.
"I know some investors think the euro is going to survive, but it's hard for me to see how Spain, Italy and even France are going to manage a Greek exit," if that is what happens if the electoral result goes against the pro-austerity party, said Jacques Porta, asset manager at OFI Gestion Privee in Paris.
The weekend Greek election, though clearly important, is not a binary event that will determine the outcome of the euro zone, though it will play a large role. "I think that it seems there will be very difficult times for the euro even beyond the Greek election," said Porta.
Hugh said that, in any case, Germany is likely to get the short stick and pressure on the euro could result if the German public becomes increasingly unhappy with shouldering more and more responsibility for euro-zone woes.
"If they assume responsibility for European fiscal union, they'll load up on more debt, [and] if the euro disintegrates or Greece or anyone leaves, a lot of people will be defaulting on them," said Hugh.
A continuing stream of bad news out of Spain -- downgraded by Moody's Investors Service to one notch above junk and further into junk territory by Egan-Jones late Thursday -- pushed yields on the 10-year government bond (10YR_ESP) to all-time highs on Thursday. Moody's warned that the country may need to ask for more money down the road, beyond the week-old bank-bailout plan that has been panned by financial markets.
Italian bond yields have also been climbing virtually in step with Spain's after yields rose at an auction of short- and longer-dated paper.
Bond yields have also been rising in such "core" European countries as Germany and the U.K., with some investors retreating to the Swiss franc. The Swiss National Bank on Thursday vowed a solid defence of the level of 1.20 francs per euro and warned that the rising currency will be a weight on the economy for the rest of 2012.
"The market sees two tail risks, and both are not good for Germany," said Marc Chandler, head of global currency strategy at Brown Brothers Harriman. "For the first, there is a movement towards greater fiscal union under which condition Germany will have to share a greater part of its wallet, balance sheet and credit."
Another risk involves disintegration of the euro, for which Germany could have significant obligations. Still, Chandler said that if investors are thinking the euro zone is going to break up, it isn't being reflected in the dollar-euro exchange rate, which has recently held in a range around the $1.25 level.
He pointed to the online prediction market Intrade, where investors can buy or sell shares in an event they think will or will not occur. Investors are currently betting there is a 38.5% chance that a country currently using the euro will exit before midnight Dec. 31, so a clear majority believes that will not come to pass.
Hugh said the euro probably has about three to six months to do what it needs to do for survival, though International Monetary Fund President Christine Lagarde has said officials have just three months to save the single currency.
The process of figuring out whether the euro will stay or go could be lengthy. The EU is holding a summit June 28-29, but European Council President Herman Rompuy has said it would only involve "building blocks," with detailed plans not available until October, media reports said.
Apart from the Greek elections, Chandler pointed to several additional intensifying risk factors, saying Cyprus is likely to ask for a bailout soon, Portugal may need an extension on its aid by year-end, Ireland is asking for the same deal for its banks as Spain's banks got, and Italy is increasingly a "hot spot."
Plus, of course, the honeymoon is about to end for French President François Hollande, who, Chandler said, will soon have to come up with a budget that includes spending cuts.
"It's going to be a long, hot summer for investors," said Chandler.
Christian Tegllund Blaabjerg, chief economist at FIH Erhvervsbank, believes a bet against the euro zone or a Greek exit is a long shot, he said. "I do not believe there is any chance Greece will leave the euro zone.
"First of all," he explained, "Greece cannot afford it."
Blaabjerg referenced forecasts that the purchasing power in the country would drop 50%, with costs of such items as a liter of milk doubling. Other estimates, he said, point to shrinkage by nearly 40% of Greek gross domestic product in the wake of such an event. "No society," he said, "could sustain that."
Blaabjerg said that, while clearly trades are being made on a possible Greek exit, what is likely going on is that Greek politicians are seeking an easing of their budget-deficit goals and are willing to put scare into the world that the country could exit the euro if some leniency is not shown it. For 2014 Greece is expected to bring its budget deficit to under 3% -- it was 9.3% in 2011 -- which has little chance of happening, said Blaabjerg.
He admitted that further risks exist, among them Spain's banking crisis and potential problems in Italy, but, ultimately, Blaabjerg said, Germany is going to be the reason the euro survives, because it has so much vested in it, from history to the fate of its own export market. A collapse of the euro would mean the return of the deutschemark, which would be reborn as an extremely powerful currency, rendering the country's goods extremely expensive abroad.
"Germany, as a huge nation and the most powerful in Europe, has learned from history. They will do anything they possibly can to make the euro zone survive," said Blaabjerg. "If [that means] that they will have to write out very, very big checks, they will write out very, very big checks."
Addressing those who might still wish to wager against such an outcome, Chandler warned that retail investors generally have no business buying complicated instruments such as German CDSs, which they neither need nor typically understand.
A better idea in this climate, he said, is cash, suggesting noninstitutional investors stash investment money in U.S. dollars or Swiss francs. Even the negative yield on the 2-year Swiss bond is preferable to losing funds elsewhere, he said.
"Will Rogers once said that sometimes the return of your money is better than the return on your money," Chandler said. "We are living in a time where cash preservation is a key driver."