Sunday Musings: Debt Disasters

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MarketWatch featured an interesting story titled “Debt disaster fears rumble from Athens to London.” Here are a few highlights:

Rumors of a debt disaster are swirling around Europe, from Athens to Madrid and all the way to London.

Investors have rushed to sell Greek bonds since the newly elected government of George Papandreou made a startling revelation: the deficit will soar to over 12% of gross domestic product this year, well above previous official projections.

Greece’s predicament has escalated concerns about contagion in other European countries whose finances are in poor shape. Just this month, the ratings of Greece have been cut both by Fitch Ratings, and, late Wednesday, by Standard & Poor’s, and major agencies have warned Spain and Portugal of possible cuts.

The market reaction has been swift, and brutal. The euro has dropped below the key $1.50 level. Credit-default swaps on Greek government debt — essentially, bets that Greece will default — have ballooned.

Irish and Spanish institutions also have seen extreme bouts of turbulence of late.

The most vulnerable countries like Greece and Spain indeed confront a mounting debt burden, which will likely lead to more ratings downgrades and more market sell-offs. The path to fiscal health will require painful, unpopular reforms.

But, most analysts agree that the European Union will, if necessary, bail out its members and never let a country’s fiscal situation deteriorate to the point of sovereign default. Those rescue expectations continue even as terms of euro entry explicitly forbids such moves.

Despite all good intentions of the EU to “assist” its members, the money has to come from somewhere. It’s not that alleged “strong” members of the Union are flush with cash and operating on the plus side of their balance sheets. Others are having their own financial issues as well with more money going out than coming in.

Even if financial support in some form is rendered, and I am sure it will be, it will nevertheless rattle world markets. That’s what I meant when I previously referred to an outside event that can at least temporally pull the markets off their highs.

If Greece or any other country defaults on their obligations, or at least the potential exists, the whipping boy of the past (the U.S dollar) all of a sudden becomes the darling of the world again that everyone wants to own. Recent events have supported that view as the bullish dollar chart (UUP) shows:

A bottom seems to have formed, but it will still take more upward momentum before the long-term trend line is crossed to the upside. Extreme bearishness on any asset will very often lead to opposite moves; and the dollar maybe no exception.

I currently have no positions in UUP but will consider it once the break of the trend line gives me the go ahead.

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