Thursday, December 17, 2009

European Warning Signs

With the help of the European Central Bank (ECB), Austria announced on Monday that they were nationalizing its sixth largest bank, Hypo Group Alpe Adria. The bank was relatively small with assets of over 40 billion euros; however, it was considered a subsidiary of the German state controlled bank Bavaria BayernLB. BayernLB is much bigger with 416 billion euros in assets on its balance sheet, which is why this news sent systemic risk shivers down the ECB’s spine. This event certainly adds to recent fears surrounding the stability of the European banking system, and coupled with sovereign (individual country) risk has brought the European Union into the limelight.

Some of the ominous headlines over the past few weeks have included “Dubai’s Debt Default Shakes World,” “Credit Agencies Downgrade Debt Linked to Greece and Dubai,” and “Ireland, Greece May Leave Euro.” The accompanying stories highlight the serious risks that exogenous, or external, events contain. Central banks worldwide recognize that they must continue to flood the system with liquidity in order to maintain asset price levels and avoid contagion. Loan losses and debt burdens are still important issues that nations must face as we move into a “real” recovery. The hope is that all the stimulus “juice” will lead to this real recovery before the debt burdens cause sovereign defaults, which would have very negative implications if they occur.

At the moment, the market seems to be handling the news quite well. There were a few hiccups directly after the Dubai and Greece announcements, but stocks quickly recovered to their recent highs. Currency movements have been a little more noticeable. The U.S. dollar has started to move higher versus the Euro, although the downtrend started in March remains intact. Bearish bets on the U.S. dollar have been decreasing lately as investors take profits in that trade and cautiously position themselves for year end. This is an interesting development and we will be watching closely since many positions held by Pinnacle have benefited from a falling dollar.