Clear Signals That Market Risk Is Elevating

It’s no secret the economic data in the U.S. and other major economies have rolled over. That’s why bond yields have taken another nose dive — hitting record lows in Germany and nearing record lows in the U.K., the U.S. and Japan, as shown in the chart below.

The bond market is telling you directly …

“Forget the thoughts of recovery and hunker down for more economic pain and crisis.”

While most of the banter through the latter part of 2009 was about an imminent run-in with inflation, the reality is, without demand, there’s no inflation!

Deleveraging is keeping demand depressed, making deflation the big threat. Indeed, especially given the world’s bloated debt problem.

The last thing you want when you’re saddled with debt is deflation. In a deflationary environment, money increases in value, but it’s much harder to come by. So those with debt tend to have a more difficult time servicing that debt.

That doesn’t bode well for economies that have recently been exposed as “at risk” of default.

When you put the pieces of the puzzle together, it seems clear that the sovereign debt problems that served as a warning signal in the first half of this year will end in government bond defaults and currency devaluations.

That’s why, even as the global financial market’s attention to those threats has calmed in recent months, it’s particularly important to keep a close eye on the developments that will re-elevate the status of the sovereign debt crisis. And Europe remains the home to the most vulnerable.

So now, let’s take a look at five, recent key developments that translate into elevated risk for all investors …

Elevated Risk #1:
Hungary

Hungary isn’t part of the euro. But European banks own a lot of Hungarian debt, and much of it is denominated in euros and Swiss francs. Therefore, when the Hungarian forint weakens against the euro and Swiss franc, the debt gets harder for Hungarian borrowers to pay.

With that in mind the outlook for stability in the country’s finances has deteriorated.

PM Orban said the Hungarian public has had enough of belt-tightening.

Hungary was an early recipient of an IMF/European bailout, taking EUR20 billion in 2008 to help avert a default. Now, the Hungarian government has pushed back on the fiscal tightening requirements for IMF funding …

In fact, Hungary hasn’t met the criteria that came with the funding, and has made it clear that it isn’t willing to try. With that in mind, just two months ago the spokesman for the prime minister warned that Hungary was another Greece — in danger of default.

Elevated Risk #2:
Ireland

Last week Irish government bond yields returned to a near extreme spread against German yields. The reason: Anglo Irish Bank, which is already nationalized, needs another EUR 20+ billion from the Irish government.

The market is again bidding up the credit default swaps on Irish banks and yields on Irish government debt. Recently the government had to pay-up for a short term debt offering, to the tune of 76 percent more than it did for a similar offering just three weeks prior — nearly double the yield!

Elevated Risk #3:
Greece

Greece reported Q2 GDP — down 3.5 percent annualized. The goal in Greece has been to reduce its grossly bloated deficit-to-GDP ratio. And they’ve taken tough austerity measures to address the numerator in that ratio. But consider how much more challenging it becomes when the denominator in the ratio (GDP) keeps declining — one feeds the other.

Moreover, the civil unrest in Greece seems on a path to explode. The reports from the streets read like something out of the Great Depression.

Elevated Risk #4:
Slovakia

Slovakia’s parliament decided they didn’t want to provide their share of aid for Greece, an early sign of how the euro zone’s attempt at solidarity will likely play out — a failure.

Elevated Risk #5:
Uneven Euro-Zone Economic Performance

The German central bank this week raised its estimates for 2010 growth from 1.9 percent to 3 percent. I wonder how that sits with its austerity-laden neighbors to the south. As time passes expect the political fallout to build.

Germany is in much better shape than other euro-zone members.

Sure, it may seem like these threats have already been handled. The European Financial Stability Facility and the ECB’s involvement in the euro zone government bond markets have given a reason to conclude that the problems in Europe have been solved …

But when push comes to shove, we’ll likely find that all of the $1 trillion worth of promises made to stabilize confidence in Europe won’t materialize. And we’ll see the weak countries that are living with tough austerity and the strong countries that have committed to transfer tax payer monies to the fiscally less responsible saying “no more.”

In sum, any one of these rising risks could become the catalyst for another round of sovereign debt fears — which could easily turn into debt defaults and contagion, making safety and preservation of capital the priority.

Regards,

Bryan

P.S. For more news on what’s going on in the currency markets, be sure to check out my blog, Currencies Corner. You can follow me on Twitter, too, and get notified the moment I post a new message. 

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