The Greeks have played ball, the European Union (EU) finance ministers have signed off, and the European Central Bank (ECB) is giving the EU liquidity, so what gives? In the parlance of an American movie: “Hey dude, where’s my rally?”
Well, despite the most obvious advancement of the issues that were spooking the stock market in August and September last year, nagging doubts remain and these are being exploited by those who just can’t get their heads around the fact that the Dow is now in all-time-high territory.
By the way, when interest rates are close to zero and governments are throwing money at economies to create demand as well as jobs, it’s not surprising that companies are making profits, which in turn drives share prices.
However, there is a mentality (which can be understood) that says, how can all of this last with debt levels so high? This nagging doubt takes the steam out of rallies, but even the lagging Aussie stock market with its millstones of high interest rates and high dollar is up 11% since late September last year.
Anyway, despite the obvious improvement in circumstances linked to Greece, the market again is worrying about credit-default swaps.
These are financial products which gained infamy when the world’s biggest insurer was nearly rendered ‘dead’ in 2008 at the height, or maybe it was the low, of the GFC.
The New York Times pointed out that European policy makers “aimed for a voluntary debt exchange that would not initiate the default swaps, fearing that payments on the swaps might set off destabilising chain reactions through Europe’s financial system.”
But despite the €130 billion package to help Greece, it’s now possible that swaps could be triggered. These are virtually insurances against someone not coughing up with their debt repayments.
There are suggestions that the Greeks could create a credit default swap crisis, which would jeopardise the banks that are exposed to bonds bought from Greece. However, there is some good news if we can believe it – European reports can have credibility question marks over them.
“A stress test of the region’s banks last year did not reveal large, unhedged exposures on swaps written on government debt,” The New York Times reported. “In nearly all cases, banks that sold insurance also bought a similar amount, which balances out their exposure.”
The fear is that a bank, which is supposed to be underwriting a default swap, fails and this creates a snowball effect that leads to an avalanche of failures.
“Counterparty risk has been the great amplifier,” said Walter Dolde, associate professor in the School of Business at the University of Connecticut to the Times. “Sometimes an avalanche starts with a snowball.”
Right now this is the kind of alarmist story that emerges when a market looks like it is ahead of itself and, while it cannot be ignored, there are well-trained experts who dismiss these alarmist predictions.
“The fears about the market are small potatoes,” Professor Duffie of Stanford said.
I don’t have as much confidence as Duffie, but I also don’t have the same expertise as him. I cannot believe that the International Monetary Fund (IMF), the ECB and the EU – the so-called Troika – could have proceeded with the €130 billion debt deal without factoring in the debt swap challenges.
And given the ECB surprised many by lending cheap three-year money to European banks to the tune of €489 billion in December and another big round comes next week, I think that should be sufficient ‘insurance’ to allay market fears. We will see sell-offs ahead, but not crashes unless there is a real curve ball from left-field.
By the way, CommSec’s Craig James thinks the worst of the EU nightmare is behind us. If he’s right, the rally will return some time this year, but I suspect we will see some serious testing of the newfound optimism seen in stock markets since October last year, and particularly since January.
That’s why I have my stress under control.
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Also in the Switzer Super Report
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- JP Goldman: Finding growth with small-cap ETFs
- Vas Kolesnikoff: Don’t get fooled by ‘underlying profit’ results
- Andrew Bloore: What to do if you exceed your contribution cap