July 19, 2010

Some optimism amid the caution

Despite the success of the Greek bond auction last week, this Michael Casey article at Wall Street Journal still pleads for caution. However, I cannot help but see optimism in this article's looking ahead to credit expansion sometime following the three-year austerity programs many of the eurozone members are now putting themselves through:

"...with the euro 8% higher than its early June lows as markets prepare for Friday's much-anticipated release of European bank stress-test results, investors should remember that the euro zone's debt problems haven't become less serious. German Chancellor Angela Merkel didn't call it Europe's "existential crisis" for nothing.

RBS Capital Markets estimates that financial institutions hold €2 trillion in private- and public-sector debt issued by the troubled countries of Greece, Spain and Portugal, a figure worth 22% of euro-area gross domestic product.

Whether a default actually plays out, the systemic risks associated with that enormous debt overhang should keep investors in a cautious mood. RBS believes it justifies a yield as low as 2.75% on 10-year Treasury notes for some time--almost a quarter point below its current level.

In recent weeks, markets have ignored ratings downgrades and willingly lent to Spain, Portugal and Greece. But a few successful debt auctions doesn't get them out of the woods. And, in any case, Greece's debt sales were merely short-dated benchmarking issues; the bulk of its financing needs are covered by the EU and the IMF.

...All these countries are embarking on aggressive fiscal austerity programs to cut their deficits by a third in three years. That will shrink their revenue base and for some time make it even harder to repay debt.

The European Union must go through with this. Recapitalizing banks will better prepare them for future credit expansion and make them more competitive. Meanwhile, more cross-border cooperation among governments, coupled with fiscal housecleaning, will give the euro zone more institutional ballast.

Still, political differences and fragmented policies will make the process a tough one, not least because the struggling peripheral countries can't devalue their way out of the crisis.”

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