Beware PIIGS Default Fears Becoming a Self Fulfilling Prophecy & Ramifications

5 02 2010

Over the past 24 hours, the European Commission added more pressure on Greece to rein in their deficit. Portugal reported weak demand for their bonds at a recent auction while Spain raised its budget deficit forecasts.

Concern about PIIGS default is becoming a self-fulfilling prophecy by driving up credit default swap (CDS) rate spreads on PIIGS bonds.

A Strengthening Downward Spiral Into Default

Credit default swaps, which measure the cost of insuring against a default of debt continued to rise with Portuguese CDS spreads hitting an all time high. The reason why the market obsesses over CDS spreads is because the higher the spreads rise, the lower bond prices go as investors demand higher yields to compensate for higher perceived risk. This of course in turn makes financing for the PIIGS more expensive, raises their deficit interest payments as a percentage of GDP, and makes them even less credit worthy and less able to borrow funds needed to fund ongoing operation.

That makes default more likely by further feeding the uptrend in CDS spreads and borrowing costs, until these countries are effectively shut out of credit markets as their bonds sink to junk bond levels and yields. They cannot avoid default on obligations coming due without their assumed ongoing access to credit.

EU “Just Talk” Attempts At Mere Spin Control Isn’t Helping

Unfortunately the problems in Europe aren’t getting any better and the European Commission’s cautious endorsement of Greece’s budget plan or ECB President Trichet’s attempt to downplay the situation by saying that Greece is on the right track has failed to pacify investors.

Trichet’s admitting that EU deficits could “burden” or influence monetary policy was correctly seen as dovish. If that is true, then until the PIIGS resolve their deficit problems, the ECB may put off plans to raise interest rates. According to the German Finance Minister, the government is assuming that the ECB will keep interest rates at 1 percent until 2013 – and this ominous forecast may be part of the reason why the EUR/USD fell sharply today, putting it well behind the current timetable of the US for raising rates.

If EU officials simply think they can let this problem run awhile in order to lower the Euro and boost exports, then they are playing with fire. See PIIGS Bad For Euro, Good For Euro-Zone? How To Profit. They would be assuming that they can manage expectations and market emotions. That’s a very dangerous and dubious assumption indeed.

The PIIGS are Not Just an EU Problem-But a World Problem

A look at Thursday’s performance of the S&P 500 is eloquent proof that trouble of this scale in one of the world’s major economic blocks threatens global markets as a whole. See The PIIGS Are Everyone’s Problem, Here’s The Solution for details.

Trading Ramifications

Until there is a solution to backstop the PIIGS, another major correction in the spectrum of risk assets is becoming a near certainty barring incredibly good news elsewhere. Risk assets include stocks, commodities, and risk currencies (like the Euro, Australian, New Zealand, and Canadian dollars). Similarly, expect continued strength in the US Dollar and Japanese Yen. The Swiss Franc would normally also be expected to rise because it too is a safe-haven currency, but many expect Swiss National Bank intervention in order to keep Swiss exports competitive in the Euro-zone.

In sum, unless something is done very soon to effectively calm markets and keep PIIGS borrowing costs managable, what began late last November in Dubai could soon arrive as another market and credit crisis on Main Street, Everywhere.

Things can unwind very fast once they get started are are neither easily predictable or controllable. Remember that Lehman Brothers had AAA rated paper until days before its sudden death. Just over a year ago, the mere threat of a few major banks closing was enough back then – imagine the effect of a wave of sovereign defaults in the heart of the develped world?

Remember too, that even US bonds have recently been virtually boycotted by foreign investors, Japan’s credit rating is now on negative watch, and both the UK and US have had not subtle warnings of similar threats to their own ratings.

DISCLOSURE: NO POSITIONS

 

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