A few of my thoughts (and concerns):
1) Credit Default Swaps (CDS) basically act like an insurance policy to bond holders in case of default. Last night’s plan has Greek bond holders taking a 50% haircut on their bonds. The powers that be at the International Swaps and Derivatives Association, who decide what is and is not a default, say this is not a default (ask your bank if you can only pay half of your mortgage and see what they say). I see two big problems with this – first of all, somebody is going to challenge this. I can’t image everyone is going to “voluntarily” accept this. If I am a fund manager holding Greek bonds it would be my duty to challenge this as a default and get paid my CDS “insurance”.
Barclays already stated earlier this week that:
“In our view, there is little doubt that a large notional haircut of c. 50-60% would be considered a credit event, consequently triggering CDS contracts.
In addition, if CDS do not cover the losses, isn’t this a signal to other struggling EU countries to increase their debt level since they too may get a 50% reduction in what they owe?
2) PIIGS Interest rates are going to go much, much higher. If I am going to purchase bonds in an EU country after Greek bondholders take a 50% haircut, I am going to want to be paid a much higher interest rate since there is a chance of the EU pushing another deep discount on bonds if that country gets in trouble.
3) €35 billion is held by Greek pension funds – with a 50% haircut, the Greek pension system will be very underfunded.
4) I am having a hard time finding anyone to write a positive research piece on why this was a good deal. In fact many analysts have said that the €1 trillion to backstop this whole project needs to be two to three times larger.
5) Lastly, what I find very interesting in all this is Greek bonds are trading in a manner that shows that bondholders are expecting yet another haircut down the road.
It seems the EU was able to put a band-aid on a gaping wound. At some point, more will need to be done.
So where does this leave the US equity markets?
I keep seeing comparisons to the 2008 market. One of the best analogs I found, was over at Tim Knight’s site, Slope of Hope:
The chart eerily lines up with the 2008 market almost perfectly. If the chart holds true, then we are on the verge of another big decline. (Please don’t put too much faith into these charts – I’ve seen investors get wiped out blindly following charts like this).
However, the US equity market is very overbought in the short term and some profit taking would be expected at this point. In addition the S&P500 is currently trading at its 200 Day Moving Average (DMA). As I have mentioned before, the 200 DMA is the line in the sand for traders. Most traders are bearish below the 200 DMA. If the market can trade above this level, then I think we will see negative sentiment turn and we should see a nice year end rally.
However, if we start to see a challenge from bondholders on the Greek deal, we may see a stronger decline than just profit taking.