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When Standard & Poor’s downgraded U.S. government debt last week, everyone was stirring about the prospects of a big sell-off in the dollar and U.S. Treasuries — but it didn’t happen.
Instead, we witnessed a mass sell-off in nearly all other markets around the world.
Why? Because this is a global economic crisis … not a U.S.-specific economic crisis.
And as we found in 2008, there simply aren’t many safe places to hide in this depression-like environment. In the end, the world’s deepest, most liquid capital markets and currency — U.S. Treasuries and the U.S. dollar — are favored, despite the downgrade.
That indeed makes a clear statement: A downgrade to U.S. government debt is the equivalent of a downgrade to the global economy.
As I wrote in my July 30 column …
“The loss of risk-free status in U.S. government debt would likely spread to other sovereign ratings. After all, ratings are relative — not absolute.”
Already the risk adjustment is underway and so is contagion. Everything is being priced down relative to the downgraded credit worthiness of the U.S. These risk profile adjustments may not be reflected yet by an actual ratings downgrade, but they are being reflected in price.
That has been clearly seen in bank stocks. In fact, on Monday U.S. banks fell the most since 2009.
I also said back in July …
“Perhaps the more troubling part is the systemic damage it would cause.”
In Europe, the story has been all about the dreaded PIG — Portugal, Ireland and Greece. And then in recent months Italy and Spain came under fire, which required the buyer of last resort — the European Central Bank — to quell the downward spiral in those government bond markets.
But this week, one of the two core engines of Europe, which is also one of the key orchestrators of managing the euro-zone crisis, is in the crosshairs: France.
The chart below shows the credit default swaps of France (orange), the U.S. (red) and a major French bank (black).
You can see in this chart the markets are pricing in nearly twice as much risk of a French government default than they were in early July. The difference between the orange line (France) and the red line (the U.S.) indicates that market participants think that France is three times more likely to default than the U.S.
With that, it’s no surprise that French banks also came under attack this week …
In advanced economies, banks often have sizeable exposures to their own domestic government debt. Therefore, when sovereign debt gets downgraded, bank creditworthiness tends to be downgraded, too.
And the vicious cycle is set into motion — where bad banks drag down sovereigns and bad sovereigns drag down banks.
Defaults Ahead
As we’re seeing, there is no painless way to avoid the economic shocks associated with a badly overleveraged world.
The general consensus has been that inflation would be the favored solution. That’s precisely why gold traded north of $1,800 this week.
But despite central bankers’ best efforts, inflation isn’t in the cards any time soon. Record low yields in U.S. Treasuries confirm that.
And austerity doesn’t seem to be working either. Take Greece for example. Greece has been operating under the austere requirements of the EU and IMF for more than a year. Yet things haven’t gotten better for Greece; they’ve gotten worse — across the board as shown below.
To sum up the above table: Since adopting tough austerity measures, the Greek economic activity is contracting more aggressively. Its debt burden is growing, led by continued worsening deficits — precisely what the austerity plans are crafted to reduce.
The risk premium in Greek government bonds is higher, government revenue is lower, spending is higher and Greece needs even more money to stay afloat.
Put simply: Austerity is not working!
One thing austerity is doing, though, is its killing global growth.
And that’s not good for the outlook of commodities. And historically, a common trigger for global sovereign debt defaults happens to be … falling commodity prices.
As I’ve said many times here in Money and Markets, in a world still working through a historic global financial crisis, we should expect downgrades and we should expect defaults. For your investments, it’s about preservation of capital.
Regards,
Bryan
P.S. My World Currency Trader members aren’t sticking their heads in the sand praying for the best. That’s because there is always a bull market in at least one currency. And to learn how you can position yourself during this global unrest, be sure to watch my latest video.
{ 7 comments… read them below or add one }
Brian, if austerity won’t rescue Greece’s economy what, in your opinion, will?
@quick… Nada.
I’ve read various economic analysis and commentary for some 30+ years. Every once in a long while someone comes along that has good insights, who has educated themselves well from a broad perspective rather than letting prejudiced opinions on what “should be” get in the way of facts of what “is happening”. Thank you Bryan.
Relating to the good question above, “if austerity isn’t working, what will?” to the situation here in amerika and the future… one can only look back to the day when then Pres. Reagan commissioned a study which discovered that if they eliminated the welfare dept. itself, they could give each person on welfare at the time $60,000. Bloated govt was, is, and always will be the problem. The more govt, the more regulation, the more regulation, the more brakes on economic activity, the more taxes stealing prosperity and economic activity. Who loves big govt and encourage more laws and lots of red tape and grievous regulation? Big companies, corporate amerika which aims to thwart it’s competition being small business, the growth engine of America. Why? Multinationals have the resources to deal with all that, to get around it. Small biz typically doesn’t. (Found in another newsletter writers book “Call It Conspiracy”) And for all you, like some friends of mine, who don’t want to believe in conspiracies… Grow up and quit fearing being called a conspiracy theorist. If you knew just how at risk your investments were to those who conspire to take your money, you’d probably need to change your diapers. Anyone remember Bernie Madoff? Enron? After hours mutual fund trading by the selected few? Arther Anderson? Goldman Sachs co-located monster computer at the NYSE responsible for the flash crash. The list could fill a book. Read the back chapters of “Reminscences Of A Stock Market Operator” to understand how things were done in the by gone era. It’s just more sophisticated today. …And just because they shut down the worst in Arthur Anderson doesn’t mean the rest aren’t guilty and still doing same today.
Bryan states “preservation of your capital” for good reason. And that doesn’t necessarily mean your bank is safe. Kudos to Martin Weiss for his Bank Ratings!
vj
Hi Bryan
Well done again. It is interesting, how in many respects the ordinary man in the street is ‘preserving their capital’ because they have had a shift in confidence. I’m betting on the consumer at the moment who are disappointed in their global sovereign governments. Fat, bloated, unable to rescue confidence from complete disasters like the corruption in the banking system. Until consumers can see someone on their side then we will all be preserving capital and the cards will fall where they may.
Bryan, second the earlier compliments to you, about reality vs. theory, and your level-headed observations, in general.
Whatever corruption &/or conspiracies that may prevail, isn’t the basic problem fiat currency?
And, its related features of fractional reserve banking, with inadequate reserves; selective accounting; and politcally selective taxation?
Have you a guess about any new “world” currency that may be in the offing (“ecu,” or similar)?
If so, would such an instrument not be likely to become just another paper note, politcally defined and administered?
Or, is a different outcome likely, possibly involving a metallic standard, internationally, or within any modern nation, the U.S. included?
Dear Bryan:
“For the most part I agree with your article except when you say this:
But despite central bankers’ best efforts, inflation isn’t in the cards any time soon. Record low yields in U.S. Treasuries confirm that.”
You see, Bryan, when the Fed prints money out of thin air based on nothing here is what happens – first of all it is a form of defaulting because they are paying back the debt in worthless dollars eventually. Second, it IS inflationary. Have you been to the grocery store lately? Do you buy gas at the pump? Corn is at an all time high. A four pack of toilet paper that was $1.50 two years ago is $3.50.
Also you must know that the PPI does not include food and fuel. How dumb is that? I think that the only place where inflation does not exist is at the Bureau of Labor Statistics and in your column.
My bet is that commodity prices will rise. In fact for the past 25 years commodities have out-performed the stock market. Please give a listen to what Jimmy Rogers is saying about the commodity markets. I think he is right.
Best Regards to you and I do read your column and enjoy your insights even if I don’t agree with you this time. Tony Ruda
Bryan your prediction for 2011 is turning out to be true except for one huge point: the dollar continues to weaken despite the turmoil in Europe!! To be fair, I was sure the dollar would strengthen during the type of turmoil we have had so I’m not blaming you for the boo-boo. Conclusion: markets can trade anywhere!