Yesterday's news was about a potential Greek default and it caused a global market selloff. Today, hopes of preventing a Greek default are causing markets to rally. This alternating news flow is repeating over and over again. Investors should pay attention to the big picture however and not the noise of the day. The important thing to realize is that we are in a second global credit crisis.
Credit crises follow certain patterns, which include: recognition of overpriced financial assets, money flowing into safe havens, increased market volatility, rising costs for financial insurance, and various forms of government action to stop the problem. The specifics of the current credit crisis are below.
1. Government debt is being downgraded. This happened in Italy yesterday, the U.S. in early August and many times in Greece. This is the upfront recognition of the problem, which is almost always widespread public knowledge by the time it happens. In 2008, securitized debt containing subprime real estate loans was downgraded in mass, frequently from the triple A ratings that had previously been given.
2. Global money is flowing into safe haven U.S. treasuries. When yields hit lower levels than a previous credit crisis or all-time lows, this indicates this is happening on a mass scale. U.S. government two-year notes had a yield below 0.15% at one point this September 19th. During 2008, the two-year held above 0.60%. The ten-year yield has fallen below the 2.04% low in 2008 and below the all-time low of 1.95% in 1941.
3. Global money is flowing into safe haven currencies. In 2008, this was the U.S. dollar and the Japanese yen. In 2010, this is the Japanese yen, the Swiss franc, and gold (which needs to be thought of as a currency if it is to be analyzed correctly). The Swiss franc rallied so much that the Swiss stopped it from trading freely. The Japanese have also taken action to try to lower the value of the yen.
4. Stock market volatility has increased enormously. In 2008, there were a significant number of mini-crashes (a drop of 5% or more in one day). These were more common in the U.S. back then. Now they are more common in Germany, but they have been happening here as well. The flip side of mini-crashes is sudden sharp moves up in the market. These are also occurring.
5. Bank stocks are the focus of the big moves up and down in the stock market. U.S. banks and other financial stocks really got hit in 2008 -- a number of the companies themselves went under. This time it's European banks falling the hardest. One-day drops for some major EU and UK banks have been as high as 10%. Bank stocks aren't dropping that much in the U.S., but they are underperforming other sectors like technology.
6. Credit default swaps have hit record levels. Credit default swaps (CDSs) are bond insurance and they became a big news item in 2008 when they rose to unprecedented levels. While CDS rates for Greek sovereign debt have hit records and are rising for the other highly indebted EU countries, they have also hit records for some UK and EU banks in 2011 indicating a worse crisis than in 2008.
7. Major and ongoing bailouts are taking place. The EU had to bail out Greece in the spring of 2010 and then Ireland and Portugal. A second bailout for Greece had to be arranged this July, even though the first bailout was supposed to have taken care of Greece's debt problem. In 2008, the U.S. had TARP and arranged for failing banks to be taken over by stronger banks (Bank America is now in trouble again because of the legacy loans from the banks it absorbed during this period). Fannie Mae and Freddie Mac had to be nationalized.
8. Central banks are buying bonds in the open market. The EU has been buying up Italian, Spanish, Irish and Portuguese bonds in order to hold down interest rates in those countries. As long as it has an infinite access to funds, this strategy will work. The Fed began buying U.S. debt instruments in the fall of 2008 during the Credit Crisis.
9. Global coordinated central bank intervention took place last week. The need for global action is a consequence of the interconnectedness of the world financial system. A major problem in one region (in 2011 this is Europe, in 2008 it was the U.S.) will invariably spread everywhere. Central banks coordinate their activity to try to control the contagion.
10. The global economy is turning down. Problems in the financial system impact the real economy and they can turn a shallow downturn into a major one as has happened in 2008. Economic figures throughout the world have flattened and there are some warnings of a bigger drop to come (extremely low consumer confidence numbers for instance). GDP contraction in a number of regions will be the final confirmation that another global credit crisis has occurred.
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.