Category: Economics

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.

There will be a huge quantum shift coming in the financial markets, and this is mostly inspired by the fiscal mess that countries such as the United Kingdom and the United States will be facing in the medium term future.

It has to do with the concept of the “risk-free rate”. Most formulas in finance reference the US government bond or Eurodollar (essentially an interbank short term interest rate) as the “risk-free rate”, where all other financial securities are referenced from. So if the 5-year US government bond is trading at a 2.5% yield and General Electric issues 5-year debt at 3.2%, typically the financial literature would state that the bonds were sold at 70 basis points over. The spread of yield, rather than the absolute yield itself has typically been the market benchmark in determining how creditworthy a corporate issue is.

This is going to change, mainly because the risks inherent in the reference securities will be significant to the point that it will start to distort the concept of the spread.

It is very unlikely that the US government will default on their debt; instead, the road to their fiscal recovery will lie upon debasing their currency. An investor in General Electric would still face the same inflation risk as an investor in US government securities; however, the big difference in modern finance is that an investor can hedge their currency risk and solely take on the default risk of the security.

As a result, it will increasingly be seen that corporate bonds will be trading at lower yields than their government counterparts under the belief that the market thinks the corporation is more likely to pay off its investors than the government.

Thus, the finance variable of the risk-free rate must not be solely relied upon – just as how Newton’s Laws become unreliable when dealing with objects that are close to the speed of light, the risk-free rate becomes unreliable when sovereign defaults start becoming non-zero possibilities.

Quantitative traders that fail to adjust for this in their models will end up losing a lot of money for their clients.