Another day, another country looks to be heading towards bankruptcy.
Greece was last night downgraded by ratings agency Fitch from A- to BBB+ and was placed on negative credit watch. That means there could be more downgrades to come.
The Greek budget deficit is currently 12% of GDP. And that makes a mockery of the stability and growth pact of the Euro Zone which requires member nations to have a 3% deficit limit. What a farce.
Not only that, but the Greek government debt will reach 130% of GDP next year.
But the really interesting thing about this situation is to understand what the repercussions of the downgrade are.
The Greek banks have been playing the carry trade by borrowing from the European Central Bank (ECB) and then investing in Greek government bonds. This is a fun game where you borrow low and lend high and then laugh all the way to the bank.
Well, actually they are the bank. So they just laugh.
This is a merry old dance until someone does something really unfair like downgrade the bonds that you’re buying! In the last month 10-year Greek government bonds have sold off from 137 basis points over 10 year German bunds (German bonds) to 220 points over German bunds.
The wider the spread, the greater the perceived risk. That’s nearly a full percentage point in a month.
When interest rates go up the value of the bond naturally goes down. A full percentage point sell off in yields corresponds to a large fall in the value of the bonds. And Greek banks are full to the eyeballs with Greek bonds.
Now suddenly, the fun game of making free money doesn’t seem like so much fun. Because they’re losing money instead. Poor banks.
Now let me think, is there anywhere else in the world where banks are borrowing money from their central bank at really low interest rates? Is there anywhere else where they’re using that money to load up on long term government debt?
And is there anywhere else where government’s interest rates are kept low by all of this buying by the banks?
Hmmm. How about America? The land of the free… lunch… for banks.
This is the most enormous carry trade. The government gets what they want by keeping their interest rates low at a time when they need to borrow a huge amount of money.
The Chinese aren’t buying as many bonds as they used to because they’re not selling as much stuff to the Yanks. Plus they don’t trust the Americans not to turn their currency into little more than toilet paper.
Not only that but the price of oil is a lot lower than it was a few years ago so the Middle East isn’t recycling as many petro dollars into US bonds either. Therefore the banks have been enticed into buying US bonds by lending them money for nothing so that they can make the difference in the yield.
The only problem with this game is that the banks are loading up on bonds at a time when interest rates are at their lowest in a generation. Which way do you think yields are going to go from here over the next few years?
Especially since last night we were told that both the UK and the US are at risk of having their AAA credit rating downgraded as well!
Oh dear. Suddenly it’s starting to look a lot like Greece. Except 1,000 times larger.
What appears to be free money for US banks now, could end up being a noose around their neck before long. Who’s going to bail them out then?
That’s led to the markets taking a battering on the back of the news about Greece.
The main point to take out of this is that Dubai has been found to have no clothes on, and now the Greeks a few weeks later. Who else is swimming naked?
Credit default swaps on sovereign debt around the world have been going higher and higher in the past few months. The term “treasury yields” has become an oxymoron because there is no yield and stock markets are resting near their highs after rallying 60% in less than a year.
Something has to give before long.
The free money from the Fed is coming face to face with the reality of economics.
It’s for that reason I’ve positioned Slipstream Trader subscribers to be as market neutral as possible.
We’re short one of the Australian banks, a transport stock and an oil stock. But we’re also exposed to upside from new technology in the energy sector and to the recovery in fertiliser stocks next year.
There’s also some exposure to the cyclical recovery in the Steel sector.
The philosophy I’m using is to take some money off the table as quickly as possible. That way I can lower the risk profile of the trade. In effect it turns the trade into a free call option.
As the positions are sitting now, there’s the potential to swipe some decent short term profits, and then leave the rest of the position to pick up some longer term gains.
As any trader will tell you, it’s important to be nimble in responding to any signs of a sustained pullback in prices. Because I’ve no doubt that when the music stops on this rally, the sell off could be vicious and quick.
Memories of last year remain fresh in many people’s mind. They won’t need too much prodding to press the panic button.
Editor, Slipstream Trader
for The Daily Reckoning Australia