Tyler Durden's picture

From Foreign Exchange Research, Barclays Capital

The key lesson from the ERM crisis of 1992 and the Asian crisis of 1997 is that contagion can emerge quickly and often in unpredictable ways. Unwinding of leveraged positions by distressed market participants, herding behaviour among investors, and loss of liquidity that gives way to general flight to quality can all lead to heightened correlations between markets and, in extremely circumstances, set off a self-filling crisis on a regional/global scale. There have been clear signs over the past week that the distress in the Greek government bond market is increasingly being felt in other euro area countries such as Spain and Portugal. The most likely explanation of this development is the “demonstration effect” – the Greek crisis is likely to have caused investors to re-evaluate the fundamentals of these countries. Spain and Greece may not have strong financial or economic links, but their fundamentals have a lot in common.

The possibility of contagion of the Greek crisis may not end with Spain. There is a presumption among investors that in the worst case scenario (and we are not there yet) the EU will give Greece financial assistance. If this is an isolated event, the effect on the overall public finances of the EU is unlikely to be substantial. However, a bailout of Greece may make aid to other countries in similar situations more likely (moral hazard). A series of open-ended bailouts would not only undermine the fiscal positions of core euro area countries such as Germany and France but, more dangerously, would weaken their political commitment to the continuation of the euro area project.

This is probably why Greece is exerting what may seem to be a disproportionate influence on the markets of other euro area countries. We can see this by using the principal component analysis (PCA) to identify the common drivers of the EU government bond markets. Our exercise focuses on Germany, France, UK, Spain, Italy, Sweden and Greece. Figure 3 presents the factor weights of the first two principal components for the past six months. The first two principal components can be interpreted as latent factors capturing the majority of the variation (the r-square is a cumulative 80%) in bond yields across the  various European countries. They illustrate that while Greece has been a relatively small part of the primary common driver of the major EU government bond markets, it has been the most important component of the secondary common driver.

It is often found in PCA that it is difficult to attribute a particular principal component to a specific economic driver. However, while we can probably view the first principal component as capturing the common factor for the European interest rate cycles, one interpretation of the second principle component is as a reflection of the common sovereign risk. The fact that the factor weights for the likes of Greece, Italy, and Spain carry a positive sign, while Germany, Sweden, UK and France carry negative weights, would support this interpretation. We also note that this second principal component can explain 20% of the joint variation of returns of government bond yields over the sample period.

Global dimension of sovereign crisis

If it was a mistake three months ago to view the Greek crisis as a localized event, it would be a mistake now to see it as a euro-area-specific event. Indeed, global sovereign risk premia, which declined steadily in the first half of 2009, have been all moving higher at varying speeds since last September (Figure 4).

Sovereign CDS has a short history. To get a sense of where sovereign credit risk premium is now relative to history, we need to find alternative measures. One such proxy is swap spreads (differential between the fixed rate leg of interest rate swaps and government bond yields). While the usual interpretation of very wide positive swap spreads is heightened counterparty risks and flight to quality, the natural interpretation of very narrow positive swap spreads (or wide negative spreads) is that it reflects high sovereign credit and refinancing risk premium. Figure 6 plots the average 10y swap spreads for the 10 largest developed economies in the world (US, Japan, Germany, France, UK, Italy, Spain, Canada Australia and Sweden). It demonstrates that the level of the spread is currently a two standard deviations event relative to the past twenty years. In this sense, it may not be an exaggeration to say that general developed country sovereign risk premium is at a 20-year high.

The same chart shows that swap spreads were negative back in January 2009 when the market had to digest the news of President Obama’s $787bn stimulus program but these concerns eased through most of 2009. Can that happen again? We would argue that the easing of sovereign risk is due in large part to the Fed’s large-scale asset purchase program, which we have argued in the past (The case for a stronger USD in 2010, 27 November 2009) extensively created a bond shortage (Figure 5). With the BoE deciding to pause in its asset purchase program this week and our view that the Fed will follow suit in March, the bond market will struggle to digest the record sovereign issuance in the pipeline globally this year. This means that all else being equal, sovereign credit risk premium can remain at the current elevated levels or even rise further. From this point of view, the risk is that yield curves could continue to steepen, inflation breakevens expand (Figure 7), and swaption vols rise again (Figure 8).

Implications of sovereign credit risk crisis

  • Increased general sovereign credit risk premium will have obvious market implications:It is clearly negative for cyclical and risky assets. Over the past year, the markets have become used to the idea that policymakers are not only all willing but they are also all powerful when it comes to crisis response. In so far as higher sovereign credit risk premium will constrain the ability of the policymakers to respond aggressively to future crisis via fiscal policy, at a minimum this calls into question the assertion that they remain all powerful. Higher sovereign risk premium also implies that crowding-out effects associated with more expansionary fiscal policy will be greater.
  • Increased sovereign credit risk premium can lead to flight to quality where more-liquid government bond markets and countries with stronger fiscal positions will benefit at theexpense of less-liquid markets with weaker fiscal positions. The USD will benefit from the relative liquidity of the US Treasury markets. In addition, as we have been arguing since December, the USD will also benefit from the relative improvement of the US fiscal position in 2010.
  • The JPY has had few friends over the past few months as investors have focused on Japan’s deteriorating fiscal story and its high debt overhang. This is why short JPY positions were very popular until the past few weeks. What would be the effect of a general increase in sovereign risk premium for the JPY? We believe such a development may turn out to be ironically JPY positive. This is because of Japan’s low dependence on foreign financing. One way to see this is by comparing JGB yields with Treasury and Bund yields, but adjusting for currency risk. By this measure, we find that both US and German sovereign risk premia have increased relative to that of Japan over the past year and their relative risk premia are near their highs of the past 10 years. Thus, it is not that the market is not paying enough attention to Japan’s fiscal challenge, but it appears that US and Germany’s fiscal problems have brought them much closer to Japan.

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fresbee's picture


good work. 


I do not agree though that Greece will spread the contagion. There are four countries at the center of this crisis and most euro bulls knew that day of reckoning to come. 

But it is a win win either way for EURO. 

There are two possible way this will play out:

1. 4 Nations (I will refrain calling them PIGS as it is derogatory) agree to EU Bailout in which case

there will dicsipline in their budget bringing down EU deficit from 6% today to 4.5% in 3-4 years. Advantage EURO!!

2. 4 Nations do not take EU bailout and they a re kicked out of euro area: Best possible solution and Advantage EURO as its deficit will again be less than 3%.


Now coming to the US side of the story: Deficit has not chance of being less than 10% for the next 10 years. 




Internet Tough Guy's picture

There is as much chance that Greece gets kicked out of the Union as there is that California gets kicked out of US. Both will be bailed.

Missing_Link's picture

It may seem like a remote possibility right now.  But events have a way of getting out of hand in the long-term.

Think of it this way: what forces exist that could seriously dent a spiraling Eurozone crisis?  The German backstop is going to do relatively little in the short term while creating much larger problems in the long term (remember what happened the last time Germany was forced into poverty for decades in order to pay off its much lazier neighbors)?

If the sovereign debt crisis continues to spiral, we could easily see large-scale riots in Europe, leading to looting, arson, and possibly even civil wars in some countries, which would dramatically increase the probability of parts of the EU splitting off.

China and the US are much less vulnerable to this type of breakdown simply because they are unified nations with extremely strong federal governments.  Both are far more capable of stamping out local flare-ups internally than the disunited, bloated bureaucracy of the European "Union."

Anonymous's picture

I would beg to differ on the part that China is much more unified. You have Turks (muslim & poor) in the west and you have Tibet in the south. Also the wealth is located almost entirely in the east creating much tension between the rural poor (see Turks) and the more afluent (Chinese).

The party will use more force to hold it together in China but nonetheless, if disaster strikes and GDP stops to rise (or better said, if wages stop to rise) and people think that the Communist Party will not be able to see them through then I believe that pandemonium might strike. Furthermore, the political union might brake down in Europe but that is not as important as the trade zone and that will last longer.

suteibu's picture

The Han Chinese are the largest race and considered the true Chinese.  It is the race of the CCP and are being actively settled in Muslim and Buddhist regions in order to dilute those populations and make more resources and land available to the Han.  Any concerns that these groups will cause any economic damage to China are just not credible.  The CCP does have a delicate balance to maintain but it is solely economic.  The only way for the CCP to lose power is if the Han rebel.  That's doubtful.

There's a better chance of seeing a revolution in the US than there is in China.

DeanTheMachine's picture

Right on.  When I was in China in the first half of 08, I kept hearing that 7-8% GDP growth was the minimum necessary to keep people from rioting in the streets.  Without that level of growth (you say correctly, in wages, although obviously GDP is much easier to measure over there) the place was a tinderbox.  That place is hardly unified - I spent some time in Yunnan, home of 55 different minority groups. Yeah, there are 600 million people in the cities with growing wages, but there are 700 million people still working the fields and living on a few bucks a day. Tinderbox I say.

Missing_Link's picture

I remain deeply skeptical that anything other than local disorder can break out in the US or China.

China has centuries of practice in keeping the country together and has never hesitated to use excessive force against its own people to ensure order.

The US has strong local and state police as well as the National Guard and seems to be increasingly willing to use the military, too, if necessary (as they did in New Orleans).  It's completely unconstitutional, but that won't stop them.

strike for return to reality's picture

The Feds will not kick CA out because (among other reasons) CA is highly valuable.  And, other states quickly would line up to be kicked out next.

Consider the "services" of the Fed... war, empire and support of a predatory banking cartel.  Consider the "services" of states and local governments... schools, infrastructure, law enforcement, fire protection, etc...

People in the US can differentiate between their country and an occupying government.  There are quite a few states that would do perfectly well without the predatory overlord, thank you.

hound dog vigilante's picture

Completely agree. You identify the anti-federalist/anti-empire undercurrents in this country exactly.


If the Feds (USA or Europe) expel one/any state for fiscal reasons, then dozens of states will line-up to be expelled VOLUNTARILY - for their own reasons/sovereignty.


From the state & citizen standpoint, the cost-benefit analysis of Federal government is a massive loser (and getting worse).

B9K9's picture

You've got the process reversed; the respective unions are the artificial constructs.

Co-operation, whether on an individual or collective scale, requires favorable future hopes & expectations in which to justify foregoing immediate satisfaction. If none appear to be forthcoming, then the social contract inevitably begins to fray and it's every man (and nation) for himself.

SWRichmond's picture

Wait a tic here, this thread has given me an idea.  Is there really a chance that all we have to do to seceed is to bankrupt our state?  That's really too good to be true.  It's too goddamned easy.  And they will think it's their idea:

Feds: "You're broke, we're not bailing you out, we're THROWING you out."

State: "Please don't throw me in that briar patch!"

Cheeky Bastard's picture

The problems we face today are a direct consequence of heading towards a post-industrial western society. With the end of monetary and economic sovereignty via open trade agreements which have one goal and one goal only; to level the income of worldwide citizenry. Consolidation of Europe into a megalithic bureaucratic monster while in the same time disregarding cultural and historic differences between European Nations + disregarding monetary and fiscal needs of sovereign European nations is what brought us to this situation. Reading Marx is never a mistake and that experience will tell you that the Order of Things is hierarchical. There are nations which are bourgeois and nations which are the proletariat. Post industrial age which was conceived due to experiences of WWII will ultimately lead to Global Equality, which is ultimately a lie. While the intentions of international business and political community my indeed be to prevent another WWII and atrocities committed in the name of expanding The Living Space ultimately those efforts will collapse due to Human Nature which is greed, self-preservation and in the cases of nations expansion. Disregarding the irrational side of things will once again create turmoil.   

Hephasteus's picture

It's amazing how ingrained and arbitrary the enforcement of heiarchies is. I was laughing at ATI/AMD and they are good guys compared to Intel/Nvidia. But anyway they came out with thier new DX11 low end chip nd die shrunk it from 55nm to 40 nm and kept the exact same 80 shader processors and sort of broke it's inter processor communiction (which might be good as it could provide more security since these things will make wonderful spyware processors using the frame buffer as a giant public pissing pool of code execution). But considering all the design considerations and such they could have easily gone to 120 or 160 shader processors. The manufacturing process is so complicated anyway it would have made no difference to cost, not took it anywhere signficant on it's thermal envelope, etc etc. It's just that it's the "low end" chip and thus has to represent a stupid price performance bar that funnels people to the "higher end".

It's just simply amazing how manipulative arbitrary and strange the world will become as it's more forcibly torn into competitive energies and strategic alignments and groupings that global corporate world will impose even when those groupings alignments and strategic sausage grindering of us into groups.

The typical war model that they use to control us now doesn't work on this big of a population as katherine austin pointed out. So it's pretty certain that the stupid georgia guidestone will be adhered to ADAMANTLY. It's got nothing to do with harmony with nature or our devestating effects on the plant. It just has to do with them being unable to enforce the damaging and self regulation and control (prisoner damaging prisoner ignoring guard). We broke thier control model and they are going to slaughter us. It's just that simple.

A tumor named Marla's picture

What makes you think that the bailed-out nations are going to decided that now they should have discipline in their budgets?

Once the shortfall is covered, the spending will begin anew -- after all "they bailed us out last time, right?".....

Hephasteus's picture

Money is debt. The banks create it the people who work pay it to who they give it to. They are not creating debt between external parties. It would make NO difference. There's plenty of out of work peope who would go to work to service the debt. They are simply playing a stupid head game with numbers and centralized debts that don't mean anything to anybody other than there is real debt intertwined with the ficticious debt in there. Theres not enough "false" drains to control it. Stupid art stupid easily manufacurable goodies and drugs work but a little too well as they are too hard to reverse the ill effects. If the drug companies EVER discover methods to get people off all the major super addictive drugs watch out. Every drug will be legal and expensive as hell. They'll just net you lke a wild animal and clean you up before you kill your entire family to buy your next fix.

jmc8888's picture

1. Will never happen. If it does, revolution in PIIGS countries.  Their social spending isn't the problem.  If you think it is, get ready to go for a ride as you will not understand what lies ahead.  Everyone that thinks social spending is the problem, will be shocked and awed at what will unfold. 

2. First it would destroy the Euro..but let's say it didn't.  Then euro would probably rise as those countries are kicked off.  Euro 2.50/1 dollar possible and Germany's exports don't implode? Yeah right.  Anyone think the banks and corps of Euroland survive at such levels? Man would their debt load be expensive. 

3. U.K. is bankrupt, eastern europe is bankrupt, so on and so forth.

But hey I can be wrong.  We're all entitled to our own opinions. 

It's just I don't see this as a social spending problem, I see it as a broken system that is crushing everything around it.  Whatever doesn't feed the beast, gets destroyed by it.  Of course if you feed it, it'll crush you anyways, because it's the feeding of the beast over the past 10-40 years that has led us to our current situation, and it was the skipping of a single meal that the beast unleashed its wrath. 


Again we have seen no economic improvement in the US for over 40 years.  The numbers just got bigger and more rigged.  We just cut costs and pooled more at the top.  That's it.  The system has been breaking since Vietnam.  You also might want to review why we got off the gold standard.  Who forced us off.  Why it was such a dirty deed to get someone to do your dirty work, then complain it cost too much. 

Of course this was going to come to a head in 87, but greenspan discovered the magical derivative, whose ascension from relatively zero to 1.4 quadrillion provided the liquidity that was our fake economic expansion (but in real terms) that was basically the 90's.  But once the beast of derivatives got too big, once it's spillover got too much, the system started breaking at the seams. 

It's like we fed a beast because he could work harder and do more than the normal person.  But then the beast got so big, he ate all the food and it did not matter whether or not he worked harder or better or got more done, he simply ate too much.  That's derivatives in a nutshell.  What it once provided, it now taketh away.

fresbee's picture

and I also believe ECB is playing this crisis to dry out the egos of these countries. Nothing is out of control in my view.

aus_punter's picture

let us all know how much money you lose

pros's picture

It's not even a contagion issue--
it's a solvency issue.
The PIIGS have incurred more debt than they can service...
banks around the developed world are still largely insolvent, as well..
surviving on explicit and implicit guarantees and other government support and subsidy.
there's no one left to save any one else.
the drowning can't save each other.
and forget china, the ponzi scheme now being exposed by Chanos.
Look at the Swissie----CHF----their banks have big problems, and too big to save, but their economy depends on banking.
eventually the swissie will get crushed.

The dollar will rule for quite a while.
"In the Land of the Blind the One-eyed man is King."

Missing_Link's picture

"In the Land of the Blind the One-eyed man is King."

I think I know the eye you're referring to.  I remember seeing it in a triangle, hovering over a pyramid somewhere.  Now where did I see that  ...

hound dog vigilante's picture

Dollar dominance is dependant on MUCH more than just reserve currency status (which is diminishing quickly, btw). The dollar's domestic status (being pulled alternately towards inflation/deflation) is at serious risk. If inflation or deflation truly take hold domestically, then the dollar's relative FX strength is a moot point and the game is over, imo.

fresbee's picture

That is the point. Dollar is not even the one eyed king. It is more blind than one thinks. 

"banks around the developed world are still largely insolvent, as well..

surviving on explicit and implicit guarantees and other government support and subsidy."

Am yet to see a FDIC style crisis in euroland inspite of all of the issue in greece and portugal.

What exactly is the issue here? The government not able to finance its deficit. In case of greece it is 54 bn in June. That is puny amount but ECB will use that to bring these 4 countries into line and once and for all close down the issue of peripheral countries issue plaguing the EURO. 


Post that the attention turns to US where there is not even a willingness to accept that there is deficit issue that needs to be cut down.





Anonymous's picture


Anonymous's picture

OK, I'll take the other side of this trade!

Missing_Link's picture

Nothing says "I have a single digit IQ" like all caps.

saulysw's picture

PIIGS = Portugal, Italy, Ireland, Greece, Spain.

It's not in the ZH glossary, and I think it should be....

... with a note that some people are finding it an offensive acronym (is that why it's not there??).

I need more cowbell's picture

Perhaps GIIPs is the more accurate, and less offensive, acronym?


The world at large is in a very precarious position, and the implosion of this house of cards cannot be modeled. Chaos theory rules the day, and all we can do is watch it unfold and try to do the best we can to plan, but be ready to react quickly to a rapidly changing landscape.

Tommy's picture

How about SPIIG?  Or is that even more offensive?

Anonymous's picture

GIPSI'S. And I pissed myself laughing.

Missing_Link's picture

Or even GIIPSI's.

"Hide your kids; the GIIPISI's are coming!"

Missing_Link's picture

Oh, damn!  Looks like Anonymous and I thought of that at exactly the same time.  LOL.

Anonymous's picture

GIPSI -- that shouldn't offend anyone.

SteveNYC's picture

Agreed. The beauty of it all is that nature is toying with the human race and this situation is already absolutely pre-programmed to evolve the way she wants it to. Watching it unfold, watching "leaders" and central bankers who think they can exercise control over this situations is hilarious. They don't know that the outcome is already determined, they are just unconscious players in the greater game helping it unfold.

Watch and learn.

Anonymous's picture

No way back to the strange attractor,
system has been perturbed too much to get back
in proper orbit.
Fractal currencies have infinite number
but zero value..

A tumor named Marla's picture

Overextended Assholes Whose Financial Irresponsibility Has Put Their Citizens' Financial Lives At Risk

OAWFIHPTCFLAR  - it's not cute, it doesn't spell any words, but it defines what they are

Dan Duncan's picture

While you're at it, please also make this as an addition to the ZH Glossary:


Dork--An annoying twit that takes offense at acronyms like PIIGS.

Anonymous's picture

We just need Morocco to show signs of distress and then we can call them GIIMPS.

bruce wayne's picture

Maybe Monaco, to continue the EU theme.

Anonymous's picture

If PIIGS is offensive, lets change it
to SigIp. Sounds militaristic,but when WWIII
starts, it will fit ....

Jefferson's picture

The ratings agencies responsible for intentionally misrepresenting the credit worthiness of CDOs, thereby, bankrupting much of the developed world vis a vis required bailouts of insolvent money center banks are now leading the charge to downgrade sovereign debt. Sovereign debt CDS are being utilized by the globalists to torpedo the financial systems of developed nations and accelerate the collapse of the obsolete nation state paradigm in order to make way for global government directed by the IMF/BIS/FSB.




Anonymous's picture

You fuckin ruined my weekend.....

dan22's picture

If Greece was to default on her debt the banks of the country will collapse immediately. At that event their will be no way for the government to save the depositors of the banks since will not be able to print or borrow money. The implications to the credit markets for such an event will be enormous since no bank will want to lend to any bank in Portugal, Italy, Ireland, Spain and maybe others. Since this will be the first time since the crisis began in 2007 that depositors lost money it will cause a panic and it is very likely that  there  will be an immediate run on the banks of Portugal, Italy, Spain and Ireland at a time when the countries themselves are unable to raise capital


Handle with care's picture

You also need to factor in the effects of private bank exposure to non-Euro economies. In my view the real risk is in the Eastern European, non Euro currencies.

Greece for example has a very high level of bank lending to Eastern European countries and Turkey.  German and Austrian banks have immense levels of lending to Eastern Europe.  I read somewhere that Austrian banks have lent an amount equivalent to 120% of Austria's GDP to Eastern Europeans.  Much of this lending was in Euros, so declines in Eastern European currencies raise the servicing burden for local borrowers who therefore default in ever greater numbers.  This was the situation in SE Asia in 1997.  Most of the corporate borrowing was denominated in dollars as most of these countries had fixed exchange rates against the dollar so the risk was seen as low.  When the pegs collapsed entire industries were incapable of earning enough local currency to pay a dollar denominated debt even without the accompanying collapse in local demand.

Its not too hard to see a scenario whereby crisis in Greece forces a selling of assets or calling in of loans to these already vulnerable Eastern European countries which causes a secondary currency crisis in those nations and a race to the exits.

Having lived through the Asian Economic crisis the situation looks dangerously similar

moneymutt's picture

very interesting, makes a lot of sense...I had same issue about East Europe debts and EU banks as you expressed adn surprised it was not raised in this article.....who will be Malayasia in this case? And the issue that Europe is not only region with the flu this time...

I need more cowbell's picture

Excellent points. As I remarked earlier, this is a global house of cards, or dominoes if you prefer ( I do love those youtube vids of thousands of dominoes in colorful themes- maybe the next time the kids can choose Dante's Inferno ), and it is unknowable how the implosion will unfold, exactly. Only that it will.

Missing_Link's picture


In the best case, a few of the peripheral nations of Europe implode, teaching the world an important lesson in belt-tightening and curbing your debt, but is halted before it brings down the EU.

In the worst case, it leads to a full-on EU implosion that takes the US and China down with it.

Anonymous's picture

yes - and the FX swap lines extended by the fed have ended as of Feb 1, 2010. No more free USD liquidity - ya'll are on your own now - good luck!!