Euro, death spiral

It looks increasingly likely that the Euro has entered a death spiral: Spreading sovereign debt crisis is weighing on bank capital which requires more government supports, causing more stress on government debts.

One hope is for ECB to become the lender of last resort, an idea that Germany has consistently blocked.

The latest European Summit was all about sumitting to the German will of tighter budget control, but without any economic stimulus for the troubled nations. The implications can be deadly.

The 10-year Italian government bond yield is back up to about 6.5%. If it hits 7%, Europe will be back to the full crisis mode again, much sooner than the summit "leaders" have expected.

What the bond markets are saying

It's often very important for equity investors to look at what the bond markets are saying.

The long-term yields of US Treasuries have stabilized after the December FOMC meeting. They were creeping up since the Fed indicated its intention to do QE2, and especially after the bi-partisan decision to extend Bush-era tax cuts. US government has no trouble borrowing. The upward sloping yield curve is re-assuring for bank stocks and general equities.

European countries are a different story. The Euro crisis is pretty much still with us. Credit spreads for Greece and Ireland continued to climb in recent weeks. The Greek bond spread is now wider than it was in May, 2010 before it was bailed out by EU and IMF (see Atlanta Fed Financial Highlights). All eyes are now on Portugal as its government are trying to convince investors that they can narrow their budget gaps. The yield on Portuguese 10-year bonds stood at over 7 percent as of last week, according Bloomberg. Can ECB and IMF manage the situation before the crisis spreads to Spain? Investors are not convinced.

In the US, a worrisome development continues to be the muni market and state budget crisis. Illinois is the poster-child of the fiscal mess. The state's bonds have the highest spreads of any state. Illinois's 10-year bond spread has widened in recent weeks to 2.1 percent above the benchmark. A year ago, that spread was less than 1 percent... meanwhile, Bernanke's testimony last week made it clear that the Fed has very limited power to bail out the states.

The bright spot is US corporate bonds. Companies are taking advantage of investors' hunger for yield and the general belief that the corporate sector is healthy and may be poised to deliver the much-needed hiring. Corporations have sold more than $35 billion of investment grade bonds in the first week of 2011, according to the Wall Street Journal, on track to reaching the highest amount sold in the year-opening week since 1995.

Taken together, we agree that it may be wise to invest in US equities, and focus on companies that conduct businesses in states that are relatively healthy and can take advantage of the needs from the emerging markets. Avoid European exposures for now. And be vigilant about systemic risks posed by the Euro crisis and the US state budget crisis.

We do not think China's and India's inflation problem pose such a systemic risk to global financial markets, but it's something to watch out for.

Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

The European debt crisis ...

Greece. Bailed out.
Now Ireland.

But the sovereign debt crises, and Euro crisis, are merely delayed. See Krugman's article "Eating the Irish." See also some other discussions by economists.

It's striking to see how the bond market and the sovereign CDS market have behaved this year.

(Data source: Atlanta Fed)

The Greek bond spread continues its rise after the bailout. Ireland's looks to widen further, even after today's decrease. The fundamental economic problem has not been solved.

Next in line is Portugal, but the elephant in the room is Spain, because of its size and its huge unemployement rate of 20%.

How would all these affect the US? Here is an interesting analysis.

This is one of the big risks that can derail the global recovery, and the advance of the stock market.