What was behind today’s sell-off?
Panic hit Wall Street today. While not many things changed within the last 24 hours, investor sentiment crossed a tipping point where skepticism and fear transformed into panic. Last week’s negative interest rate cross-over on the 1-month Treasury already suggested that investors were parking their money. Today, widening credit default swaps in Eastern European countries (especially Greece, Portugal, Spain, Italy, and Ireland) and a failed bond auction from Portugal appeared to be the catalyst for the sell-off.
The January 27th Bloomberg article, Swaps Trading Surges as National Deficits Rise: Credit Markets, was a good indicator of what was to come this week. Bloomberg claimed that traders were buying protection against default on sovereign debt at more than five times the rate of company bonds. Additionally, the cost of protection on Portugal had climbed 23 percent, Spain 16 percent and Greece 5 percent. Specifically to Portugal, contracts had jumped to $9.6 billion since October 9th and the cost of protection had doubled since September 2009.
Sell-off Catalysts
Portugal’s failed auction today was the final blow necessary to derail the stock market, which was already worried about Greece’s debt problem and the Chinese credit tightening. The Portuguese Treasury and Government Debt Agency sold €300 million of 12-month treasury bills (at higher than anticipated yields), which was well below the anticipated sale of €500 million in bills (WSJ). Portugal’s debt chief Alberto Soares dismissed the market views that the auction had failed. As Zero Hedge noticed, Dick Fuld also dismissed Lehman’s inability to borrow money and raise capital right before it’s collapse. We know what happened that time around.
AIG-like counterparty concerns also fueled the equities downward spiral. According to BNP Paribas, the notional amount of CDS contracts on the Eastern European countries is large and concentrated (FT). This creates concerns about whether protection sellers would be able to honor their contracts in the case of an actual default. Given that a few months ago CDS sellers probably did not see any real potential for sovereign defaults, they are likely to be over-extended like AIG was in 2008. Investors sometimes forget that ‘tail risks’ can actually happen.
Trader uncertainty and panic also affected the markets today. As a CNBC contributor mentioned, traders were flooding him with instant messages asking what “he was seeing” and what was driving the powerful sell-off. Nothing new had really changed, so why the the spiral downward movement? As expected, uncertainty generated fear and fear induced selling.
Selling to avoid overnight risk was also probably a factor in the end-of-the-day selling.
Lastly, another catalyst to the sell-off was the strong dollar which was helped (besides sovereign debt concerns) by the exiting of investors in the dollar carry-trade. Borrowing at very low interest rates and chasing basis points around the work can work for a while; however, carry positions are likely getting crushed as the dollar is rallying nonstop.
This Time is different
But what really seems to be happening? Confidence is fading on the Eastern European countries. Both French and German ministers have made it clear that there would be no bailout for Greece or any other European Union country. As a result, the following quote from This Time is Different fits the profile of what may be happening:
“But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”
“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence-especially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits.
Here are the CDS charts of Greece and Portugal from today.
Click on images for full-sized graphs.
Goldman Sachs is expecting a 72,000 job loss. I’m also bearish on the data. We’ll see what happens tomorrow.
