Risk in Europe

The risk rally is on and have gone beyond my initial expectations. As I wrote in my last post Italy bond yield would be the most critical thing to watch if they move beyond 6% they would move up sharply. As we saw in last week Italy bond yield moved up 20% and reached 7.5% before correction.

If we look at the given chart we can see that Italy's bond yield are just moving back to the trend line and if they stay above 6% then they will move up in future. Therefore this is only a temporary lull before the storms comes back.

In the chart we can see the primary trend line at around 5% level and secondary trend line above 6%. Only if Italy's yield goes below 5% I will change my view on sovereign debt crisis. .

Italy 10 Year bond yield

According to Italy's debt yield is following the same path as Greece did in 2010. Greece bond yield saw a spike in May 2010 and then corrected only to rise significantly after that. Italy may see similar patter but the uptick in yield should not be as vociferous as that of Greece was. 

Greece 10 Year bond yield weekly chart

I think the main yield to watch from here is that of France. The yield difference between France and Germany have been widening since last one and half month and it had reached a new high. France may become the next country to be attacked by bond raiders and if France comes under attack, it would prove to be the end of Euro. 

Comparison between 10 year Bond yield of Germany and France

I think the path from here is very clear.  They want to use EFSF to leverage or provide loan loss grantee and I think both wont work. A leveraged EFSF will be like a CDO with bad underlying assets and therefore no one will lend money to ESFS, because if EFSF looses money then no one will stand behind EFSF to repatriate that loss. (Last week in a 3 billion auction ESFS could only find buyers for 2.8 billion, rest was unsold).

I think ultimately ECB will be forced to become lender of last resort and they will be forced to buy sovereign debt form all PIGS countries. Although at this point in time Germany has huge objection to this but I think the objection is more symbolic and slowly as the crisis deepens Germany will give way and accept monetization of debt by ECB.

This will give a temporary relief to the markets but this solution will fail. The reason is that ECB is not FED. FED has the advantage of USD which is a reserve currency and USD is backed by one sovereign nation, where as ECB is neither a reserve currency and is backed by 14 different nations and is more unstable.

If ECB starts to monetize debt the result will be a fall in value of Euro to parity (which seems more likely on chart) and high inflation in Euro zone. Ultimately monetization will result into covert default by Eurozone by reducing the purchasing power of Euro and by higher inflation. Even for equity the price of stocks may stay at present level but their purchasing power would go down significantly.

PS :- The value of Euro completely depends on the faith people have in monetary union.  Monetization of debt by printing Euro will reduce peoples faith in Euro and may cause a panic where by people will start moving away form Euro to USD. If this panic starts there is no one to stop it and it will create a massive financial shock which would make 2008 look like a good year.

The volatility in markets is more than what I have ever seen and is mind numbing. It is very hard to have a rational short term view on market prices and had become even more difficult during the current time of extreme volatility.

Therefore its better for trader to get out of their position and wait for market to give a definite signal towards which direction it wants to take. I am no longer sure of a large price correction in Equity, It all depends on ECB. If ECB choose to monetize debt there wont be any correction in nominal price of  market. Therefore I am taking a months break and hope that market will stabilize by the time I come back.