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Will Europe Order a Code Red?


The world attempts to handle the truth.


European Central Bank Council Member Axel Weber said Greece's fiscal crisis is threatening "grave contagion effects," according to the fine folks at Bloomberg.

Grave danger; is there any other kind?

Minyans should be well versed in overseas risk. Professor Peter Atwater pointed to Eastern Europe as a sub-prime borrower over a year ago. In January, we noted the risk of European Disunion in our Ten Themes for 2010 when we offered:

"The European Union is committed to the regional and economic integration of 27 member states, with sixteen countries sharing a common currency. That was a fine idea when it was first founded but the economic fallout of the financial crisis will put loyalties to the test.

Look for the Union to adopt more stringent guidelines in the coming year, including but not limited to distancing itself from the weaker links such as Greece and Ireland. Sovereign defaults, as a whole, should jockey for mind-share. This could conceivably spark a rally in the US Dollar, which could have ominous implications for the crowded carry trade."

On February 10th, we shared a salient script for what is now unfolding, A Five-Step Guide to Contagion. Given the parallels to the first phase of the financial crisis, we have a proper context for the sovereign sequel. While many points were made (read: if you haven't chewed through it, please give it a look), the takeaway was two-fold.

First, we noted the implications for a higher greenback on the crowded carry trade. Hedge funds were long "risk assets" in size entering this year, funded by the "cheap" dollar (the DXY has rallied 13% since the beginning of December). You haven't heard much about this in the mainstream press and perhaps it won't come to pass (given the staunch state of credit), but it most certainly should be on our collective radars.

Second, the simple yet scary analogy that was first shared by the sage Mr. Atwater: If sovereign lifeguards saved corporations when the financial crisis first hit, who will be left to save the lifeguards?

You, Lieutenant Weinberg?

The IMF, which presumably contained the contagion? That doesn't seem likely; we've seen that script before. Look at it this way, the FDIC was hemorrhaging capital on the way to insolvency until the Treasury issued TARP and recapitalized the banking system. JP Morgan (JPM), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley (MS) all lined up and lined their pockets. We, the people, paid the tab and we're now chewing through the "other side" of that trade.

Overseas, there are two lifeguards: the IMF, which is funded by governments from around the world, and the European Central Bank. The chief difference between the stateside solution and the sovereign sequel is the motivation of the lifeguards and the magnitude of the waves. The ECB could conceivably print Euros but it's an entirely different animal. The European Union is a monetary union with no unifying political federation.

Sovereign spreads continued to widen overnight, with Portugal (+13%), Italy (+11%), and Greece (+10%) leading the charge. That dynamic structural shift, coupled with percolating social unrest and political maneuvering -- German Chancellor Angela Merkel told parliament that Europe's fate was at stake -- will make for an interesting European Central Bank meeting tomorrow.

Kevin Depew noted on yesterday's Buzz & Banter that a significant amount of speculation was circulating about possible aggressive ECB action. At least a couple of banks sent notes around to clients suggesting ECB may cut rates. The views from euro watchers ran the gamut from cutting refi-rates to zero, announcing a quantitative easing operation similar to the Fed's move to, you name it -- everything goes to zero. This would be needed, it was argued, to fully head off the euro-zone crisis that continues to percolate. See Regulatory Risk Abounds.

While there's a world of difference between the USA and Europe, we share commonalities with regard to the state of our respective unions. There are drugs that mask the symptoms, pushing risk further out on the time continuum, and there is medicine that cures the disease, in the form of debt destruction. As any drug addict will tell you, the "high" creates a synthetic sense of euphoria before causing a crash back to reality. In severe cases, after an overdose, that crash is unrecoverable.

While the path we take is more important than the destination we arrive at, all the fancy words and engineered acronyms don't change one, simply, scary fact. The world is entirely too indebted and those cumulative obligations must eventually be paid. We can only hope a fight doesn't break out when governments around the globe reach into their empty pockets and attempt to save face.


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