News that Greece was in danger of defaulting on its sovereign debt created quite a stir in the markets back in February, and the contagion has now spread to other Eurozone countries. The big question for investors is whether the latest troubles in Greece, Spain, and Portugal will spread, and ultimately result in the breakup of the Eurozone.
After a debt downgrade in February, ratings agency Standard & Poor’s downgraded Greece’s debt again on April 27 to junk status, even as an aid package was in the works. It also downgraded both Portugal and Spain’s long-term government debt to double-A with a negative outlook, cautioning further downgrades were possible. Spain’s GDP is about five times that of Greece, so this was serious news, sending the euro currency to a 12-month low against the U.S. dollar.
While the International Monetary Fund was still working with Euzozone officials on a Greek bailout before a May 19 payment deadline, the concerns that seemed isolated to Greece a couple months ago are now looking like a serious problem with potential global impact.
Junk Status
Investment bonds rated as “junk” are considered below investment grade. These bonds have higher default risk and tend to pay higher yields as a result. In North America, the five major credit ratings agencies are Standard & Poor’s, Moody’s, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. Rating scales can vary, but typically bonds rated BBB- and higher are investment grade; ratings below that are considered junk.
Most pension and other large investment funds have restrictions against holding junk grade bonds. So when there’s a downgrade to below junk status, all these large funds around the world have to sell them, and there are not enough investors to absorb that glut. The prices of the bonds will drop and the interest rates will increase on them as a result. Greece’s debt peaked at about 16 percent after its downgrades.
Eurozone Impact
So far, Italy has been immune to these problems, but it’s considered one of the weaker Eurozone nations known as the PIGS. It has a higher debt-to-GDP ratio than Spain or Portugal, and some say it’s only a matter of time before it also finds itself in trouble. The big question is whether this contagion will turn into a European debt crisis that could bring a breakup of the European Union.
When you look at the debt-to-GDP ratios of many Eurozone countries, it seems difficult to think these problems will all just go away quickly. As we see in the table that follows, Greece’s debt-to-GDP ratio is 108.1 percent, according to the CIA World Factbook. Italy actually has a higher debt-to-GDP ratio at 115 percent.
In the past, most debt crises of this magnitude involved third-world countries whose debt was not as widely held by global investors. Many large institutional funds and banking institutions own various types of European debt. If there is a chain reaction of defaults in Europe, it could cause significant ripple effects. These could be serious enough to create a double-dip recession, the epicenter of which will be Europe instead of the United States, where the global recession of 2008 was triggered by a mortgage crisis.
A banking crisis (such as the one that took place in the U.S.) is a bit different from a sovereign debt crisis. When a bank or other financial institution goes under, shareholders and bondholders lose money. Usually, individual depositors don’t lose money. In a sovereign debt crisis, if the government decides it won’t pay its debts back, people with their retirement tied up in pension funds or other vehicles heavy in government-debt instruments will be in trouble.
Printing the Way Out of Crisis
Countries such as the U.S. or Canada, which have their own independent currency and central bank, can print money to provide liquidity to the financial system. In the Eurozone, individual countries don’t have that ability—the ECB governs monetary policy for 16 countries in the region. It’s such a unique situation. Of course, printing large amounts of money (which the U.S. has done) comes with its own set of potential future problems, but that’s a topic for another time.
I think it’s a real risk that the Eurozone could fall apart due to this stress. When a country faces financial stress, all the countries have to absorb the strain. If you are a factory worker in Germany or France and your country has been fiscally responsible, I doubt you’d be happy bailing out another country miles from your border that has been irresponsible. We may see the EU kicking countries out. If bailouts become common practice, the more sound counties will have little incentive to remain part of the Union. The whole concept of the EU is actually a bit odd in that we have this mix of very different countries with diverse cultures, some of which have had very turbulent histories and wildly divergent fiscal and monetary policies. I’m not sure it’s realistic that they will all agree on fiscal and monetary policy.
Some argue this new Eurozone is no really not all that different than when the United States was in its infancy, with separately governed regions. But what’s different is that the U.S. was more of a military-based union, and there was a common fiscal and economic understanding. I don’t think you can compare the two. We have a different situation today, and in the Eurozone, the ECB has no decision-making authority in the running of each individual country.
Impact on the Euro
As mentioned, the euro has been in decline for several months as these issues have unfolded. In January 1999, when the euro currency first made its debut, it declined to 0.85 versus the U.S. dollar. At that time, many speculated the Eurozone would fall apart. Then it looked as if things were going well, and the currency nearly doubled in seven years. Now, market participants are again speculating whether the Eurozone could fail, and I suspect that will erode the value of the euro even further. I think the ECB will have to keep interest rates low, and likely print money to finance bailout programs for weak- member countries. The economic stability of the entire region will decline, which is bad for the currency. To hedge against this kind of crisis or speculate on it unfolding, one strategy you can consider is selling euro futures.
Flight to the Dollar
The U.S. dollar has benefited from the trouble in the Eurozone. We have seen this type of flight-to-quality taking place in the past. When there risk, investors tend to quickly move into U.S. currency and U.S. Treasury bonds, even though there are other assets in other parts of the world that are as safe, if not safer. Nonetheless, investors tend to flock to the U.S. dollar and Treasuries in knee-jerk fashion first, then move their assets to other places later.
When people perceive market risk is growing, they get nervous and sell their risky assets. When you sell something, you are exchanging it for something else—in this case, U.S. dollars. Oddly, when the demand for U.S. dollar increases like this, we typically see the Canadian dollar drop, which really doesn’t make much sense because the situation in the Eurozone has nothing to do with Canada. However, the U.S. dollar is simply climbing much stronger in relation to the Canadian dollar.
Once the dust settles a bit, investors do tend to look to other countries where they don’t perceive the risk is as high, such as Canada or Australia. They may also move into what they consider to be other safe-haven commodity assets, such as gold. If you can stay ahead of the capital flow into the dollar and then other assets when you see a crisis unfolding, it can create a compelling trading opportunity if you time it right.
The European equity markets have performed reasonably well given this somber outlook, which also can provide traders interesting opportunities. If you have an opinion on how this will play out, in addition to trading euro or dollar index futures, you can also trade the DJ Euro Stoxx 50, a European stock index benchmark. Even if a crisis is averted, the European economy could certainly slow down.
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.
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