I hope my readers are also reading John Mauldin’s weekly letter. In fact, if there is only one thing my readers get from this blog, it is John’s letter. For years he has shared with us the insights of leading economic and financial thinkers from around the world. Right or wrong, what they are thinking matters.
Now, on the subject of Greece. This weekend John returns from Europe to tell us what many of us already know, but it’s still worth noting. Greece is potentially the first domino in what would be a series of sovereign defaults that will bring on a second installment of systemic global financial crisis. When you understand the risk, and that the well informed see it and are preparing for it, the current market environment makes more sense.
The risk of renewed financial crisis is shifting – perhaps has already shifted – from Box 2 on the upper right to Box 1. That is why we are seeing distribution in equities, liquidation of speculative commodity positions, and accumulation of Swiss Francs, US Dollars and Treasury bonds, gold, and other safe haven assets. The “smart money” is discounting the increasing probability of financial crisis.
Most of the dots are already connected for us to understand what is happening here. The trigger event is a default, which is a technical matter. Now, if you have seen a swap contract, it defines in explicit terms what constitutes a triggering event. For a default swap, this would commonly include a particular rating issued by one or more named rating agents – Moody’s, S&P, etc.
I suspect there is trememdous pressure on the rating agencies. We have heard that Greek (and Irish?) default is inevitable, and that a number of banks holding their bonds are technically insolvent. If the rating agency issues a downgrade on those bonds that creates a technical default event according to a swap contract, that is the potential first domino falling in a new wave of crises. If they don’t, they are exposed to losing the credibility that is their stock in trade.
It’s an impossible situation that reflects the impossibility of the debt situation. Nobody wants to be the one who “pushes the reset button” on the global economy. Nobody wants to be the one left holding the bag when the paper goes bad, so we see these odd games playing out. The conflicting interests of the citizens, bankers and politicians in the various countries – US included – are so convoluted as to make it impossible to see a consensus on a resolution of the crisis.
Where does this leave us? We’re probably looking at a disorderly resolution rather than a managed resolution, which means it’s difficult to plan for. Ultimately, as managers of our portfolios, the only thing we can do is attempt to correctly weigh the risk, exercise vigilance, and protect precious capital.
For short term traders, on the other hand, the increasing volatility presents all sorts of opportunity.