Aside from lingering Eurozone risks and central bank policy measures, bearish developments across four correlated asset classes could soon cause a major selloff in risk assets.
While Greece has drawn all the attention this past week, there are other indications that suggest markets are ripe for a potentially significant relapse in risk sentiment. Despite reports of the European Central Bank (ECB) buying Italian and Spanish government debt, Italian yields are at all-time highs and Spanish yields are at their highest levels since August. This suggests to me that markets remain unconvinced that the EU’s ostensibly comprehensive solution will actually work for countries "too big to bail."
Two-year government bond spreads between troubled EU nations (Italy, Spain, Portugal, and Greece) and Germany are all at euro-era record highs, offering another vote of no confidence on the EU plan. As well, most risk markets were only able to retrace about 38.2% of the selloff even after the idea of the Greek referendum was scrapped. So while the Greek tragedy plays out in the foreground, keep an eye on the background of Italy and Spain.
What the Central Banks Didn’t Do
Adding to the pressure on risk assets is an underlying deterioration in recent economic data—especially in Europe—in contrast to more robust numbers just a few weeks ago. Key Eurozone PMI’s fell below the 50 expansion/contraction level, and Germany’s unemployment rate unexpectedly ticked higher to 7.0%. Perhaps ECB member Yves Mersch summed it up best, saying the economy is practically "in freefall," adding the odds of a recession there are more than 50%.
In response to the weakening outlook, and in an uncharacteristic display of economic reality, the ECB surprised markets by cutting interest rates by .25% to 1.25%. But more important is what the ECB failed to do.
Newly installed ECB president Draghi flatly declared that the ECB would ! not be t he lender of last resort for banks or governments and could not stabilize the debt markets of beleaguered Eurozone countries, like Spain or Italy. Without ECB support, debt investors are left looking at highly indebted national governments promising to borrow more to guarantee earlier borrowings, and not feeling especially comfortable.
In the US, October jobs data provided little support for the notion that US growth was picking up momentum, leaving the brief euphoria following the 3Q GDP report as a distant memory. The Fed this week issued downwardly revised forecasts for 2012-2014, expecting anemic growth and high unemployment to persist over the period. In response to this bleak outlook, the Fed did nothing.
Bernanke indicated that QE3 remains an option and that it was discussed, but he also seemed to suggest that it wasn’t going to happen any time soon. It’s unclear what the Fed is waiting for given its moribund economic outlook, but for now, expectations for QE3 are dwindling rapidly, providing yet another headwind to risk assets.
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