Measuring Europe’s Contagion

Measuring Europe’s Contagion
David R. Kotok
Cumberland Advisors
December 2, 2011


“The time for literary allusions or even macroeconomic commentary is unfortunately over. While we have rehashed the debt deflation pattern more than enough for the past three years, I never dreamt that European leaders would themselves become a part of the problem.

Yesterday’s meeting in Strasbourg only served to display before the entire world the differences of position between the major eurozone countries. It would certainly do nothing to help turn around risky assets.

The Italian treasury auction this morning at 6.50% is horrifying. And the fact that the equivalent German instruments are trading at 0.03%, and even dipped temporarily into negative territory Wednesday during the tumultuous 10-year Bund auction, demonstrates just how much investors have lost visibility on the eurozone beyond a few months, and that includes Germany!

As a case in point, the German 3-month Treasury bill has dipped into negative territory ten times in the past three months.

So what explains the inverse movements between long-term (Bund) and short-term rates (Bubills) in Germany?

The answer is simple: Does a German investor really want to hold 10-year German bonds yielding only about 2% in case of a top-down implosion of the eurozone, resulting from a unilateral German decision to withdraw from the single European currency? In such a scenario, the new German currency would be revalued upward by 20%, 30% or even 50% vis-à-vis the euro. After all, the euro will have become very Mediterranean by that time while Bunds will remain denominated and paid off in euros. What a mess!”

Source: Erwan Mahé, “Ein, Zwei, NEIN” (25 November 2011)

Cumberland Advisors has decided to collect data on the European contagion issue and present the information on a series of PowerPoint slides to be posted on our website,  These charts can be found in the vicinity of the central bank balance-sheet charts, which we also track.  We will now collect data on a weekly basis, with the goal of reflecting current data on Monday mornings.  In one set of slides, visitors to our website will be able to view the G4 central banks, with the asset and liability sides of their balance sheets.  On another set of slides we will track Europe’s contagion.

We have elected not to utilize credit default swaps (CDS) as the vehicle to price default risk and contagion risk in Europe.  The historical pricing of CDS is meaningless on European sovereign debt.  It was established during a period in which CDS users believed they had protection on payments, which they subsequently learned did not exist.  The “voluntary 50% haircut” mechanism to reduce some of the sovereign debt obligations in Europe has been deemed to lie outside of CDS insurance coverage on European sovereign debt.  Participants who previously established their positions on one CDS pricing mechanism have subsequently learned that they were wrong and their assumptions invalid.  New York Times journalist Gretchen Morgenson discussed this dilemma in her column on Sunday, November 20th.  Here is the link: Scare Tactics in Greece

At Cumberland Advisors, we are going to track two elements.  First, we are going to track the interest rate on the 10-year benchmark sovereign debt of various countries.  Secondly, we are going to track the credit spreads of those countries against Germany, since the 10-year German government bond, affectionately known as “the Bund,” is the benchmark for European sovereign debt.  We have separated the countries into two groups: the “Good” and the “Bad.”  As their names suggest, the “Good” refers to those countries whose fiscal status and creditworthiness are more stable than in the other group. The “Bad” countries have poorer credit ratings, and their fiscal troubles are on a downward trend.  The “Good” countries are Belgium, Austria, France, Finland, and the Netherlands.  The “Bad” counties are Portugal, Italy, Ireland, and Spain.  Belgium is presently in the “Good” category; however, the market may be pricing in a change.

This division between good and bad was originally suggested by Erwan Mahé.  We have made only minor changes to his composition.  In all cases, we ignore Greece.  It is the “Ugly” country because it is insolvent as a governmental entity.  There is no reason to track any sovereign debt spreads or interest rates for Greece.  The government of Greece has lost market access and is now dependent upon quasigovernmental, institutional support for funding.

Note that there are two vertical lines on the charts.  One of them marks the Merkel-Sarkosy plan announcement which triggered a sharp rise in interest rates.  We have annotated this trend with red arrows.  The other vertical line marks the coordinated central bank action announcement.  Note how the central banks announced AFTER the actual peaking of rates.  Did some folks have an advance “inkling” of the action.  There are reports of hedge fund managers meeting with Fed officials prior to the announcement.  Did the “hedgies” prevail on the Fed to act.  Did they surmise that the Fed would act and stake out positions that would be front running? Was there a suspected failure of a large European bank that triggered the action.  Rumors abound.

There is a separate controversy involving Greek and other European debt.  It involves the TARGET2 payment settling system in Europe.  And there is the issue that Dr. John Whittaker, Visiting Fellow at Lancaster University, has written about.  It involves the ability of national central banks to print currency and thus add additional liabilities to their TARGET2 payments:  Eurosystem debts, Greece, and the role of banknotes.

Note that TARGET2 liabilities and currency-creation liabilities are not reflected in the balances of outstanding sovereign indebtedness.  They are in addition to it.  A technical debate rages on how TARGET2 liabilities will impact the eventual euro-crisis outcome.

We hope readers find the four charts concerning European contagion of interest.  They depict dramatic changes and how rapidly those changes are occurring.  A fifth chart shows the Bund yield and compares it with other non-euro benchmark yields.

At Cumberland Advisors, we do not have any peripheral Europe country ETFs in our portfolios.  In our international accounts, we have an 8% weight in Eurozone country ETFs, with the entirety of it in Northern Europe (France, Netherlands, and Germany). Adding the exposure we get from broad aggregate ETFs brings the Eurozone exposure to 12%.  This compares with a 20% weight in the worldwide ex-US benchmark.  In the global multi-asset class, our total Eurozone exposure is just 4%, with no specific country positions.  We continue to watch the developments closely.  We hope readers find both chart stacks of interest.  We welcome constructive comments and suggestions.


David R. Kotok

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