Bond market 'vigilantes' sink stocks
Credit bears push government debt risk to levels not seen since last April.
Despite steady improvements in corporate earnings and ongoing signs of strength in the global economy, credit markets continue to worry about rising government debt levels and troubles in weak European nations like Greece and Spain.
Yesterday Greece reached an agreement with the European Union on reducing its huge budget deficit. Deep cuts to public employee wages and possible pension cuts were part of the deal. But the credit bears weren't satisfied, and instead of covering their bets started attacking the credit of other high-deficit counties like Spain and Portugal. They also renewed their attacks on Greece after the country's largest public employees union announced a strike to protest planned wage cuts.
As a result, investors are selling sovereign bonds, buying up credit protection, and abandoning risky positions in favor of the safety of the U.S. dollar. The dollar's rise is pounding commodities and commodity related stocks. Emerging market stocks are being hit particularly hard since countries like Brazil depend on commodity exports while its financial markets benefited from a falling dollar and a rising local currency. But that's all reversing now.
With much of the recovery predicated on spendthrift politicians pumping cash into their economies while keeping taxes low, a bond market revolt would drive up interest rates and force policymakers to stop administering stimulus; instead, in order to address rising deficits, spending would contract and taxes rise. This could result in a double-dip recession. The bears know this -- and have been pressing their advantage in the shadowy and unregulated credit derivatives market.
Tim Backshall, a strategist at Credit Derivatives Research, notes that their Government Risk Index (shown above) has moved to levels not seen since the March/April 2009 market selloff. By bidding up the cost to protect against the default of countries like Greece, the credit bears have set off a downward spiral that is weighing on all risky assets.
In Backshall's somewhat cryptic words, we're seeing "a vicious circle of voluntary austerity leading to lower growth, driving Europe weakness and a flight-to-safety bid in the U.S. dollar, is raising systemic risk floors across financial and corporate spreads."
Looking ahead Brian Reynolds, a strategist at WJB Capital Group, believes the credit bears could soon start covering their positions now that the S&P 500 has breached the important 1,070 area and pushed many technical indicators into deeply oversold territory.
Disclosure: The author does not own or control a position in any of the funds or companies mentioned.
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