Euro zone: Nice rally, but risk still palpable on Greek death spiral

If you are wondering why the euro rallied sharply over the last couple of weeks, hitting a two-month high against the dollar on Thursday, the answer is that it was a self-reinforcing process that proved much more powerful and positive than I expected.

The catalyst was Greek leaders agreeing to an austerity package (i.e., more tax hikes and deeper spending cuts) in exchange for 130 billion euros ($170 billion USD) in new funds. But if Greece is indeed in a death spiral, the money could run out as fast as it rushed in over the last six weeks.

On December 8, the European Central Bank (ECB) announced a major lending program for European banks, called the Long-Term Refinancing Operation (LTRO). This proved to be much more effective than most analysts expected, including yours truly.

In short, this program created a classic self-reinforcing positive-feedback loop for asset prices across the euro zone. Here is a look at the benefits that resulted:

1. Increased demand for ECB funds stemmed liquidity risk among euro-zone banks.
2. Reduction of liquidity risk, which reduced bond risk premiums and pushed up bond prices.
3. Liquidity provided by the ECB through the LTRO helped banks to buy local sovereign debt.
4. Demand for debt by banks was followed by funds, which means more money flowed into sovereign debt.
5. This demand for European paper increased the demand for euros, in turn pushing up its value against a pack of currencies, especially the U.S. dollar.
6. Increased prices (i.e., lower interest rates) on sovereign debt increased the value of existing bank collateral.
7. Rising European bank collateral values helped push up stock prices for banks and reduce their cost of capital, evidenced by a rush of new bank equity offerings.
8. Rising European financial stocks begot more money flow from investment funds.
9. Bolstered European bank collateral reduced the need to de-lever from Eastern & Central Europe and Asian trade finance (on which European banking represents an inordinately large impact).

On this side of the pond, U.S. stocks started rocketing on the ECB’s three-year term announcement back in mid-December.

And yes, our friend Fed Chairman Ben Bernanke played a strong supporting role with his announcement that interest rates will likely remain in the cellar through 2014 if he is still the boss.

So, do we pour into Europe on this new flood of liquidity and this newfound love of the euro and European banking stocks?

If you believe the Greek situation will be resolved, this momentum in Europe could have some legs. But many believe Greece is in a death spiral that will eventually engulf the euro zone whether a deal is done now or not.

Here is a good summary of the death spiral view from Evan Ambrose-Pritchard of the U.K. Telegraph:

“This is what a death spiral looks like.

“It is what can happen if you join a fixed exchange system, then take out very large debts in what amounts to a foreign currency, and then have simultaneous monetary and fiscal contraction imposed upon you.

“Germany discovered this on the Gold Standard when it racked up external debt from 1925 to 1929 (owed to American bankers) in much the same way as Greece has done.

“When the music stopped — i.e., when the Fed raised rates from 1928 onward — Germany blew apart in much the same way Greece is blowing apart. This is not a cultural or anthropological issue. It is the mechanical consequence of capital flows into a country that cannot handle it, as Germany could not handle it in the late 1920s.”

Interestingly, even though most of the bond markets across the euro zone have surged — including Portugal, which appears to be the next canary in the coal mine — Greek bonds haven’t done much …

Greek vs. Portuguese 10-year ‘Sovereign’ Bond Yield:

The fact that Greek bonds have languished while other European debt markets have soared tells us that this charade by European leaders that Greece can be saved is fooling Mr. Market.

Maybe euro-zone politicos and the ECB can keep hope alive. But make no mistake — the risk of a major global systemic event from Europe is still very much palpable. And the shine from the Greek deal already started to wear off as early as Friday morning, as the euro and the markets started getting hit hard after Greek workers went on strike to protest the new austerity measures.

It’s no wonder, really. After all, at what point do banks stop loading up on risky sovereign debt? When that happens, it simply means parking euros at the ECB for “risk-free” yield.

This would likely mean the relative supply of euro rises compared to demand, which should help weaken the currency. And in my World Currency Trader service, we are playing these moves accordingly.

Investing in currencies is as easy as buying a share of IBM. And to help you, I’ll send you my “Currencies Made Easy” video library — a $995 value — absolutely FREE just for giving my World Currency Trader service a try.

Best wishes,

Jack