Wednesday, December 7, 2011

Message From the Markets?

Trying to understand the "message from the market" is, in my opinion, a little like looking at modern art: you see what you want to see.

For example, bond yields on Italian and Spanish debt have plummeted in the past few days. After rocketing past 7% a couple of weeks ago, the combination of European Central Bank intervention as well as a dollar infusion from the Fed has caused a large bond rally in the offerings of both countries, and yields are back below 6% this morning.

Many analysts are pointing to the action in the bond market as a clear signal that creditors are becoming more convinced that a clear and decisive action will be taken by euro zone leaders by the end of this week.

I hope this is true, but there is another possibility.

The German solution for the troubled sovereign borrowers in the euro zone is austerity: cut government spending and raise taxes. The near-term economic pain might be significant, the Germans are arguing, but fiscal responsibility is the only long-term solution.

On the other hand, as the New York Times pointed out this morning, the cure for the euro crisis might lead to significant economic malaise.

Yields might be falling because investors now believe the German solution make bonds a superior investment to most other asset classes.

Here's what the Times editorial said this morning:

But the Franco-German recipe will exacerbate Europe’s fundamental problem: lack of growth. While German officials insist that budget discipline will restore markets’ confidence, markets understand that a deepening recession will make it even harder for weak nations to repay their debts.

Europe’s deeply indebted nations certainly must get their budgets under control, reform labor markets, sell state properties and become more competitive. But that can’t be done without any growth. Germany could provide some of the needed boost: saving less and spending more; absorbing more imports from neighbors. But the plan provides for no German stimulus. In fact, the International Monetary Fund expects Germany to spend less: cutting its budget deficit to just over 1 percent of gross domestic product next year.

Trading volumes in the stock market this week have been remarkably light: investors know that the next direction for the market depends on the announcement from the euro group later this week.