Grand Delusion Update: New Bank Risks, SRM Challenges, Yet GIIPS Markets Outperform

Prices AND Risks of EU Periphery Stocks, Bonds Rising Together, & Key Mistake To Avoid


The following is a partial summary of the conclusions from the  weekly analysts’ meeting in which we share thoughts about key developments worth a brief special report – this one is an update of a prior article on the irrational simultaneous rise in the price of EU peripheral assets  AND their risks.

Last week, in an article titled Grand Delusion, we wrote about the rising demand (and falling yields) for GIIPS sovereign and bank debt despite the sad fact that default risks have increased, not decreased.

The past week brought further signs of both rising EU risk complacency AND rising EU crisis risk.

On Monday EU stock indexes rallied, led by the GIIPS indexes,  after EU regulators elected to ease the very leverage limit rules they’d recently enacted to shore up bank balance sheets and reduce solvency risks. EU banks already maintain lower cash reserves compared to their outstanding loans than US banks.

The stocks rallied because the new easing of how bank leverage ratios are calculated meant that EU banks could in theory have more cash available to lend and so ease the current credit crunch. EU stocks continued that upward march last week, again with the GIIPS continuing to perform well.

This latest intentional increase in bank risk, and bullish stock response to it, is yet another example of the disturbing growing complacency about EU risk, particularly EU banking risk, even as that very risk seems to rise each week since the start of 2014

The year began with the fatally flawed SRM deal, which raised risks of a new banking crisis, especially for the periphery. As US Treasury secretary Jack Lew said (via Thursday: “We don’t think it’s big enough. We don’t think it’s fast enough.” These flaws were basically a result of German conditions designed to limit Germany’s liability for other nations’ banking problems.

Then came the sudden bull market in periphery bank and sovereign bonds (why not – their fates remain more tightly bound than ever, right?).As we wrote here last week, peripheral debt yields are plunging to near pre-crisis levels as markets seriously believe risks in the EU have greatly diminished.

Their arguments include:

  • Ireland and Portugal are exiting their bailout programs, and Irish bank and sovereign bond sales have seen strong demand and falling yields. However Ireland has confronted its bad bank issues, Spain and Italy have yet to do so. We don’t even know how big these are. As noted below, the new single resolution mechanism (SRM) deal only makes these banks, and thus their nations, even riskier than before.
  • There are pockets of recovery, like the US and Germany, that will help the periphery. Ok.
  • There are tentative signs of bottoming in some peripheral economies. True, but these have been very tentative, and unevenly distributed to Germany and other sounder economies, with the GIIPS not seeing much improvement. More importantly the causes of the GIIPS troubles have not even begun to be fixed.
  • The new single resolution mechanism (SRM) to deal with insolvent banks and unify EU banking supervision is a positive step. The recent SRM deal makes raises crisis risk for the EU. It confirms that there will be no meaningful EU assistance for GIIPS bank bailouts, and that bank investors, lenders and large depositors need to flee at the first sign of trouble. See here for details.
  • There’s been quiet in the EU since mid- 2012. True, but that’s due to temporary measures, mostly just lending to those who can’t repay their current debt, that’s the fact. So as the disclaimer says, past performance is not an indicator/guarantee of future results, etc. That’s all the more true when the past performance was achieved with unsustainable borrowing likely to hit a wall of defaults.

See Grand Delusion for full details.


This past week brought new installments to the Grand Delusion:

  • The bull market in GIIPS equities and bonds continued this past week, with Spain and Italy stocks up, along with their bonds (and thus yields down) compared to their last sale, even while German and French government debt prices fell and yields rose since their last sale.  For example on Wednesday:
  • Spanish and Italian 2-year sovereign note yields hit fresh record lows.
  • Portugal sold €1.01 billion in 12-month bills at their lowest yield since November 2009.
  • Note that these sales occurred two days after ECB regulators had reduced banks capital requirements from 8 to 6 percent for the region’s stress tests, making these nations more vulnerable to banking crises even before we consider the recent developments like the SRM farce noted above. See’s excellent calendar here for full details of periphery sovereign bond sales last week. This happened despite further deterioration in the safety of EU debt, particularly those of the GIIPS banks and governments.
  • The European Parliament challenged the SRM’s legality, arguing that it bypasses the established legislative processes of the union (i.e. them). As with the SRM’s other basic flaws, this too is due to conditions Germany needed in order to limit or prevent its liability for other nations’ bank problems. See a pattern here? The fate of the SRM rests on whether Germany and the EU can reconcile the EU’s thirst for German funding for bank bailouts throughout the EU, with Germany’s firm resistance to that.

Meanwhile, the overall EU economic picture is little changed, which by itself suggests the rising risk of losses from rising GIIPS asset prices.

So do we start shorting these assets? No, not until we see these rallies reverse. See our special report on the EURUSD’s surprising resilience and its key lessons.


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