Dollar Starting to Pay Off

For months we have been wondering when the dollar will finally start to move higher versus the euro. The problems in Europe are massive and they will not go away. And yet the Euro seemed to be hanging around -- the damn thing has alligator blood. Well, the dollar is finally having its day. The market is pricing in a 95% chance of default on Greek debt, and Germany is prepared to shore up German banks in case of default. Euribor is spiking once again and the global system is experiencing tremendous amounts of stress. This feels eerily similar to 2008, only the epicenter is in Europe.

After a four month consolidation at levels close to the all-time-low in the dollar, the greenback has risen above the 76 range resistance and is trading above the 200 Day Moving Average (yellow line) for the first time since September 2010. Momentum is making a new high and the move is pushing the dollar above its one standard deviation trend as measured by the Bollinger Band. These are all great technical developments for our currency, but they are not great developments for the ‘risk assets,’ including stocks. Since 2008 the dollar has a 55% negative correlation to the stock market. That means when the dollar is up there is a very good chance that the stock market is down. Today, the S&P 500 is falling 2.5%.

For a brief moment there, I was in a good mood.

Would You Lend Money to Greece at 16%?

The debt crisis in Greece has taken a turn for the worse over the past week. The bailout by fellow European countries and the IMF that was supposedly agreed on weeks ago is apparently more tenuous than widely believed now that Greece has actually asked for the assistance.

As a result, the markets have responded, and not favorably – Greece’s debt was downgraded to junk status this week, causing the yield on Greek government bonds to soar. Their 2-year bonds jumped from an already staggeringly-high 7.7% last Wednesday, to 10% last Thursday, to 13% on Monday, to 15.9% yesterday!!! The market is clearly pricing in the possibility that Greece will be forced to default on its debt.

So, for those of you frustrated by the low-interest rate environment and searching for higher-yielding alternatives to paltry money markets, I ask, would you loan money to the Greek government for 2 years at 16%? After all, that’s 15% higher than a 2-year Treasury bond (see chart below). I’m sure there are some speculative investors out there, hedge funds and the like, that are in fact taking that offer. Indeed, by this morning, the yield was back down to “just” 12.3%, according to Bloomberg.

So far, the situation in Greece hasn’t adversely impacted the financial markets here in the U.S. The S&P 500 is just a few points below its recent high. However, as we know, things can change quickly, so we’ll be watching closely for any signs of a contagion effect, which would pose a serious threat to the current bull market if it occurred.

Greek-German Spread Update

Below is a chart that we discussed during our Inside the Investment Committee presentation. It is the yield of a 10 year Greek bond (orange line), the yield of a 10 year German bond (white line), and the spread between the two (yellow line in the second panel). The German bond is generally considered the safest bond in the Euro zone, and the spread allows an investor to gauge the risk level in other countries. When the spread moves higher it means that the yield on the Greek bond is moving higher when compared to the German bond, or the country is seen as riskier. And as a refresher, when yields move higher bond prices fall and when yields move lower bond prices rise.

When we showed the chart at the beginning of March the spread had been narrowing, or Greek bond prices had been rising when compared to German bonds. That was due to rising expectations of a bailout for Greece by the other Euro member states. However, over the past month the bailout has not moved forward and the spread has jumped right back to the highest point since the adoption of the euro. The bond market is definitely signaling concern over Greece’s ability to reign in this debt crisis and avoid defaulting on their bonds.

And that brings us to the equity market. This latest move higher in Greek to German spreads has been of little concern to equity traders and this has certainly intrigued me. During the last spike in January, equity markets sold off close to 10% as fiscal fear spread throughout investing circles. So are we worrying too much about the fallout from sovereign default, or are equity traders the last ones to get it?