The article was firstly published on April 18, 2012 on the Marketwise column of China Daily.
I warned in this column in early March that the equity rally had run out of steam, and argued in late March that the spike in Treasury yield was rather short-term and wouldn’t trigger another equity rally. I continue to be skeptical about the buoyant sentiment in the market given the overstated growth expectation in the US and the worsening economic outlook in Europe.
The tumbling market across major risk assets that was mainly triggered by the worse-than-expected employment readings in the US in early April has been in line with my expectation. I am not particularly worried about a down market caused by economic disappointments going forward as the downside from the current level should be manageable. However, the eyesore remains in the European peripheries.
As I pointed out in early March, the way we saw the rally during the first quarter is that equities had been playing catch-up and pricing in the improved market sentiment with a month of delay after the first long-term refinancing operations (LTRO), a funding facility by European Central Bank (ECB) that lent out billions of euros for three years to European banks and removed the tail risk of a sudden collapse in the banking sector in December last year.
The LTRO did improve the short-term liquidity problem but the long-term imbalances and insolvency remain very much unchanged. Investors should be well aware that it is about when, but not if, the debt woes in Europe would come back and haunt the market again.
In fact, sovereign bond investors seem to agree that the expiration date for this honeymoon period created by the LTRO won’t be farther than three years from now when banks return the borrowed money to the ECB. The Spanish bond market indicated this short-termism in the market with the 2-year yield dropping significantly to its lowest level since late 2010 after the LTRO and decoupled from the 10-year yield which stayed at an elevated level throughout the period.
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| Source: Reuters |
Before the Greek debt restructuring that reduced the debt value by more than half, investors thought large-scale write-downs on European sovereign debt was impossible as the ECB was held hostage with its massive holdings of debt issued by those Eurozone nations.
This thought was of course proven wrong at the end as the Greek debt held by the ECB was exempted from haircut, but this kind of misperception did help slow the pace of the crisis during the second half of last year.
However, after the nasty Greek debt restructuring in which private investors got squeezed harshly and subordinated to the ECB without any prior agreement nor notice, it becomes absolutely clear to everyone that large-scale write-down on European sovereign debts would happen.
Investors are all once bitten, twice shy, especially when the bad experience falls within the short memory of the investment world. It is almost certain that the return of debt crisis, if any, would come really fast and way more severe. While the rising Spanish yields lately may hint of the return of the debt crisis, investors, especially those with less risk tolerance, may want to shy away from risk assets before everyone does.
