How to Protect Against the Imminent Risk of a Severe Pullback
Bond markets understand how close we are to a very serious pullback in risk assets, while other risk asset markets do not.
Bond markets are demanding increasingly higher yields on virtually all PIIGS block bonds to compensate for what they correctly see as increasing risk of default. This past week alone has seen Spain’s CDS spread increase almost 7%, and Portugal’s over 6%. See the chart below [click to enlarge].
Source: CMAvision.com 04 apr 15
Meanwhile, the S&P 500 managed to break critical resistance of 1200 to yet another 2 week high Wednesday.
Gold is holding steady near 5 month highs, crude is at multi-year highs.
This comes at the same time as German and Swiss academics are preparing a legal challenge to the EU Greek aid plan on the grounds that it violates the Maastricht treaty, which could well prevent at least Germany from being able to participate in any aid package should Greece call on it in the near future.
Here’s what bond markets see that the others don’t:
Risk of Severe Market Dive From EU Debt Crisis is Growing
That Greece will need to tap this aid very soon is virtually assured, as Greece is currently forced to pay rates far and above what it can afford to pay while reducing its deficit. Current rates are only widening its deficit and undoing whatever good its spending cuts will accomplish. Bond markets understand this. They also understand that the aid plan has enough remaining ambiguities to make the availability of that aid far from certain (see My Big Fat Greek Rescue, Take 3: Summary, Pros and Cons).
Thus the mere rising possibility of a Greek default is pushing the rest of the PIIGS block closer to the edge. This is reasonable, as a Greek default, or any other, could well send borrowing costs for the rest of the PIIGS block so high that all will be unable to afford further needed borrowings and will be forced into default.
The biggest concern here is that Greece will default unless the bailout comes quickly, and bring down the markets with it.
Why? Reggie Middleton of BoomBustBlog.com sums it up beautifully in his latest article, Is the Greek Drama Over Now That Money Has Been Promised, Again?
In sum, Greece is on course for default because:
So here’s where we stand.
Bond traders still believe Greece will muddle through, though in the near term, they are getting increasingly nervous, as the rising yields show.
Not only is the standing EU/IMF plan inadequate to keep Greece out of default, it will only delay the process given the below-market rates currently offered in the plan. Not even this aid is assured, as there are growing legal challenges that could delay implementation of the plan beyond the time when it can save Greece from default.
As long as resolution of the Greece issue remains in doubt, the risk of its default and a concomitant wave of other EU defaults that could crash markets as governments and banks fall like dominos is growing.
The bond markets are right. The only question is, how long before stocks and commodities begin to reflect the ominous risks of default contagion?
How to Protect Yourself
Get ready to take defensive positions shorting risk assets or at least get out of risk assets, whatever your chosen method. When markets pull back, these include:
Forex: Long USD, JPY vs. the EUR (possibly CHF, but it’s too linked to the EUR for my taste), Short EUR. Those without forex accounts can take positions via corresponding ETFS: Long UUP (USD) short FXE (EUR)
Commodities: Short oil or its ETFs like USO. Possibly gold too as long as there is no real panic but just an orderly pullback. Gold falls with risk aversion, but can rise when there is panic. GLD is the popular ETF, though it is an index, and isn’t a substitute for physical possession.
Stocks: Short any major Index or its corresponding ETF, like the SPY for the S&P 500.
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