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9 August 2011
2008 Redo? History Doesn’t Repeat, But It Often Rhymes
finance.yahoo.com Welcome to the new world disorder.
Monday marks the first day of U.S. trading since America lost its coveted triple-A rating and traders are braced for almost anything. (See: After S&P Downgrade, 'Sunday Night, Pray' and Other Thoughts From Traders)
As indicated in futures trading, U.S. stocks fell sharply early Monday with the Dow down more than 350 points, or over 3%, in recent trading. The decline follows a global sell-off as international markets reacted violently to S&P's Friday evening downgrade, which prompted a flight from so-called 'risk' assets:
Oil futures are sharply lower, recently trading just above $83 per barrel, while gold surged to a new record above $1700 per ounce.
In Europe, the FTSE and DAX are trading down 1.5% and 2.4%, respectively.
Asian markets tumbled overnight with Japan's Nikkei 225 and Hong Kong's Hang Seng each falling 2.2% while China's Shanghai Composite shed 3.8%.
Middle Eastern markets tumbled overnight Sunday, with Israel's benchmark TA-25 index falling 7%, its worst drop since October 2000.
As if the historic downgrade of America's credit rating weren't enough, traders are also closely watching developments in Europe, where the ECB announced it would use the European Financial Stability Facility to buy debts of Italy and Spain in the secondary markets. The debt purchases will be made in exchange for promises of what the ECB calls "decisive and swift implementation by both governments" of measures designed to reduce debt-to-GDP levels. (The ECB didn't outright say debt purchases are contingent on austerity measures but it's pretty much understood that's the deal.)
Yields on Italian and Spanish debt fell Monday in reaction to the ECB's pledge but the euro struggled to maintain its initial bounce vs. the dollar. Meanwhile, the main Greek stock index tumbled 4% and the price of French credit default swaps rose amid concern it too will soon lose its AAA rating.
In a separate but related development, the G7 issued a statement Sunday evening saying it is "ready to take action to ensure stability and liquidity in financial markets." That's code for a potential intervention in the currency markets, where the dollar was trading at a record low vs. the Swiss franc.
History Repeats, Rhymes
Following last week's rout in global equities and the debts of Europe's PIIGs, the Sunday night announcements by the ECB and G7 recall the summer of 2008, when global policymakers struggled to contain the bursting of the subprime bubble. Talk of "bazookas" filling the airwaves on the financial news networks serves as another reminder of August 2008.
It wasn't that long ago, but many observers seem to have forgotten the lessons of those thrilling days of yesteryear, including that debt matters far more than equities and the law of diminishing returns appears to apply to government bailouts.
Of course, there are differences between now and then. Most notably, Europe is at the epicenter of the financial crisis today vs. the U.S. mortgage-backed securities market in 2008. Furthermore, policymakers have presumably learned some lessons from the experience of 2008, as have investors. But the Fed, ECB and others have also spent a lot of bullets and lost a lot of credibility in the past three years, as Henry Blodget writes.
For all the differences between now and 2008, the fundamental issue remains the same: The global economy is only as strong as the financial system, which is built on a very shaky foundation of trust, confidence and derivatives contracts that nobody really understands.
Just as the subprime meltdown was not "contained," neither were the debt problems of Europe's so-called periphery. Just as in 2008, the main concern today is of "contagion" — this time emanating from Europe — and you will likely start hearing the term "counterparty risk" soon enough if Europe's sovereign debt crisis becomes a banking crisis, which is precisely what policymakers are trying to prevent. (In a delicious double dose of irony, AIG is suing Bank of America for $10 billion, citing "massive fraud" on mortgage debt in the years leading up to the 2008 crisis.)
Furthermore, just as the fallout from Lehman Brothers' September 2008 bankruptcy caught policymakers and traders by surprise -- nobody foresaw money market funds 'breaking the buck' - the law of unintended consequences will almost certainly apply to the loss of America's triple-A rating.
To wit, on Monday S&P downgraded the debts of Fannie Mae and Freddie Mac to AA+. The move was widely expected given the government's guarantee of the GSEs back in 2008. But there's a lot of other debt, including munis, linked to Uncle Sam's debt rating that may suffer a similar fate, potentially leading to selling by funds that can, by charter, only own AAA rated debt. Another lesson from 2008: selling begets selling.
"Things will be different" because the global financial system is "built on the assumption of AAA at its core," PIMCO's Mohamed El-Erian said on CNBC Sunday evening. U.S. creditors have a right to be "nervous," he said, suggesting the downgrade will prompt sovereign wealth funds (like China's) to seek diversification away from Treasuries.
(Thus far, Treasuries appear to benefiting from the global unrest; Treasury prices were up across the yield curve early Monday with the yield on the benchmark 10-year note recently at 2.45%. Still,I can't help but think the loss of AAA is the latest step toward the dollar losing its reserve status, albeit not imminently thanks to Europe's implosion and a lack of other alternatives.)
Nobody, El-Erian included, really knows what Monday will bring but, almost certainly, this latest chapter of the financial crisis isn't over yet.
