Category: Economics

The European Union Bank is effectively going “all-in” by pledging $1 trillion in collateral to shore up the economies in the Eurozone.

What people should be fully aware of is that while this might delay the financial issues concerning the countries in the Eurozone, this is not going to solve the underlying problems – too many entitlements promised to people and not enough money to pay the corresponding liabilities. The only solutions are to reduce the entitlements (which is difficult to achieve politically) or raise revenues.

Clearly by stalling for time, they are hoping something might happen that would alleviate themselves of the fiscal mess they are in, but by stalling any action that would clean up the mess, it will just make it worse in the future when the proverbial excrement hits the fan.

It is my market opinion that we have not seen the end of this by any means. How to play this profitably is difficult – increasing cash allocation and playing the risk aversion card seems to be wise until such a time it becomes evident that the markets have discounted sufficient risk to account for the soverign debt mess that is looming.

The United States is not immune to this, but economists do know that countries such as the United Kingdom, other European countries and Japan are more likely to face these big macroeconomic/demographic issues before the USA will.

Countries like Canada, relatively speaking, are in decent shape. While old age security payments and guaranteed income supplements will increase as the baby boomer generation retires, entitlement payments are relatively low and can be managed. Our pension plan (CPP) is solvent and funded by real assets generating real returns (although how those assets will perform in a global debt default remains to be seen). The big liability, accrued healthcare spending, is the big political hot potato. The Canadian economy seems poised to take advantage of one major trend, mainly that consumption of energy will continue to increase – our oil industry is going to boom assuming there is no massive deflation of debt and international trade.

I still have no idea whether the deflationary or inflationary theory will win out.

The impact of the European Union’s credit crunch in their less than financially solvent countries is playing out before our eyes. Since the market has had the ability to see this event happening far in advance, I do not believe the impact will be nearly as severe as the US credit crunch. In addition, the US/Canadian direct exposure to Greek debt is limited, but indirect exposure (via the European banks, who have the real exposure) may be significant.

The obvious impact, now that this has clearly hit the media, is the following:

1. Whenever there is a financial crisis, the rush to safety always goes into US dollars and US treasury bonds. 30-year yields are down from 4.8% to 4.4% in April. Canadian bonds have seen some inflow, but not nearly as much as the USA.

2. US currency, relative to the Euro is signifciantly higher, but this has been being priced into the market over the past few months. The Canadian dollar has been relatively unchanged against the US currency.

3. Stocks will take their tumbles as people rush for liquidity and reduce risk.

4. Commodities will be lower due to less implied demand.

The EU bailout will, at most, be a band-aid for the Greek government, but does not address the underlying problem in any way, mainly that the list of entitlements that the Greek government has promised its people it cannot pay for. This should be a word of caution for those that think the government can continue to have most of its people on the dole without consequence – if there is no political will to reform entitlement programs, then the financial market will make the decision for you. In the case of Greece, it has clearly come to this point.

Greece, by joining the Euro, has removed one important tool that could have otherwise allowed it to recover – currency devaluation. Without a devaluation option, they have to make politically much more difficult choices.

In the grand scheme, Canada is relatively placed better than most European countries, as long as we don’t keep giving out entitlements thinking they are free.

In terms of future decisions, it would imply that interest rates would be kept lower with an expanded European crisis than without, so this could be a boost to fixed income securities.

I don’t think this will transform into a market meltdown like what happened in 2008, although again, I could be wrong. If the markets do continue to plunge, this is exactly what you have cash reserves for – to snap up underpriced bargains that have gotten to that price level because of other people forced to liquidate.

I earlier stated that posted rates are irrelevant, but the change in them is somewhat more relevant. The change in mortgage rates, however, are dictated by the Canadian government bond market.

As you can see, the 5-year government bond yield is at a high for the year – at 3.06%, it has not been this high since October 2008.

Today some of the major banks increased their posted rates to 6.1% from 5.85%. The best market rate you can receive today on a 5-year fixed mortgage, without going through too much hassle, is around 4.25%. This will likely go up to 4.5% soon.

Over the past 5 years, the peak for the 5-year benchmark government bond yield was 4.72% in the week of June 13, 2007. The posted bank rate then was around 7.3%, and a typical market rate on 5-year fixed rates would have been around 5.8%.

As government bond yields continue to increase, mortgage rates will also follow.