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How to Invest Amid a Summer of All Fears

Contagion in euro zone, falling precious metals may pose opportunities for investors

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A former bond trader I know often used to say, “Trading bonds is the most fun you can have with your clothes on.” Nonetheless, fun is the last thing that holders of euro-denominated PIIGS debt have been having of late.

There is yet again rising stress in some of the sovereign debt markets in Europe, which needs to be taken into consideration from a short-term tactical trading perspective, as well as longer-term investment strategy.

Europe is important to investors in the United States and emerging markets, because its large size means that its problems often cause repercussions all over the globe.

As I expected, the U.S. bond market has firmed up and the euro has finally sold off, while the Greek drama of postponement of the inevitable default has been intensifying. Two-year Greek government bonds now yield a massive 25%. That’s the bond market saying there are exceptionally high odds of a bond default or voluntary restructuring; the first is less orderly while the latter is slightly more so.

Take a look at the government yields of the five PIIGS countries, along with Germany and the United States. Three of the five PIIGS sovereign debt markets — Portugal, Ireland and Greece — have inverted yield curves (short-term bonds yield more than longer-term maturities). This is one way for the bond market to say that the state of economic affairs is notably weaker in those countries so the risk for bondholders is much greater.

country Two-Year
Government Yield
Government Yield
Portugal 11.01% 9.06%
Ireland 12.52% 10.5%
Italy 2.91% 4.59%
Greece 25% 15.58%
Spain 3.37% 5.25%
Germany 1.78% 3.08%
United States 0.52% 3.15%
Source: Bloomberg

However, the real Greek drama will start if the bond market in Spain goes into inverted yield curve territory, as intensifying problems in the little PIIGS markets are likely to cause contagion and drive away buyers of Spanish debt. This has serious implications for U.S. investors, and is likely to cause a further surge in the U.S. dollar and the U.S. Treasury market, while suppressing equity markets worldwide, beginning as early as this summer.

At present, this outcome is impossible to predict with precision as it depends on policy decisions, but it is fair to say that European policymakers do not know what to do with Greece in particular and the PIIGS in general for fear of the inevitable domino effect. Watch the Spanish yield curve for inversion — two-year notes there yield 3.37%, while 10-year bonds yield 5.25% — as a good indicator that the domino effect has started.

Article printed from InvestorPlace Media,

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