Greece was a blip compared to the havoc Italy is already bringing to our financial markets. Updated 11.10.11 @ 9:20 a.m.
On Monday, I sent the following note to a friend of mine who also pays close attention to financial markets (though he’s not trading every day like I am):
Now they’re going to go from worrying about Greece to worrying about Italy — which is a much bigger problem.
If you look at the Euro [around 1.38 when I wrote the note], it seems to me that the last jump up to $1.41 before falling off a bit again was a short squeeze. I think people have been short this for quite a while believing it will fall apart, and are giving up — meaning that it’s probably a pretty good time to short the thing now that the trade is less crowded. I have no data to support my theory…just a hunch.
If there’s one major flaw I have as a trader, it’s not trading big enough on my own instincts. And although the market did make that silly rally on Tuesday, the enormous sell-off on Wednesday seems to me more likely to be the beginning of something rather than a buying opportunity. My guess is that Monday and Tuesday were selling opportunities — that I didn’t take.
By Wednesday afternoon, the market was down, albeit less than 2 percent, from Monday’s opening and the Euro was down 2 percent, to around 1.355.
To be sure, the woulda-coulda-shoulda club of traders is a big, loud, and unprofitable one, and I can’t honestly say that I thought we’d fall nearly 50 points in the S&P or 400 points in the Dow Jones Industrial Average the day after having an impressive afternoon rally. What I can honestly say is that I did make some small downside bets on Monday, but that I didn’t have the courage of my own convictions — I rarely do — to make them bigger than I did or to add to them in any significant way on Tuesday. So while I made a few dollars trading (but lost much more in my long-term investments) on Wednesday, I made a fraction of what I “woulda, coulda, shoulda” made.
Enough about me, though.
My bigger point is this: We saw what Greece did to worldwide markets, not just stocks but also interest rates (much higher in weak countries, much lower in strong countries). Italy will be an intensive care-causing pneumonia compared to the hiccup that is Greece’s debt problem.
While Greece’s debt is a stunning 180 percent of GDP and Italy’s is “only” 120 percent, Italy’s national debt is a mountainous $2.6 trillion, roughly five times Greece’s debt and simply too big to bail out — even if otherwise a perfect theoretical candidate for the moral hazard of “too big to fail.”
And thus, Wednesday’s market meltdown (or what we would have considered a meltdown except that we’ve had so many of them recently that we’re numb to ginormous moves) strikes me as likely to be the opening salvo in a “sell first and ask questions later” market.
Markets test and punish weakness. It is how George “I hate capitalism” Soros made one of his first billions — testing the weakness of the British Pound. And you see it frequently in the stock market with headlines like “XYZ was down 15 percent today as short-sellers bet that the firm’s accounting irregularities are a sign of serious problems.” More often than not, despite investors thinking of those short-sellers — people who actually do the most homework on companies — as the villains, their real function is to expose the ugly truth — or lose money if they’re wrong.
And that’s exactly what the “bond vigilantes” have done in Italy recently, with that nation’s government bonds plummeting in price and rising in yield (implied interest rate you receive if you buy one). Over the last week, the yield on the benchmark Italian bond spiked up from 6.2 percent to about 7.3 percent, with half of the move happening on Wednesday. Asif to emphasize the volatility of the situation, the Italian government bond yield plunged by almost half a percent, down to 6.8 percent, in less than an hour in Italy’s afternoon trading. No bet is safe these days.
The seven percent level, while not inherently special, is seen by many traders as the market’s calling out “Danger, Will Robinson” (or whatever “Will Robinson” would be in Italian). As interest rates rise, it means that the Italian government must replace its maturing debt with new debt that costs it more, causing the annual budget deficit and thus the national debt to rise. In other words, if the market forces are big enough, as they are now, they can come perilously close to causing a serious problem by betting that there will be one.
There are always those politicians, regulators, and investors whose gut reaction is to ban short selling, and such bans are in place for certain stocks and bonds in certain countries in Europe and Asia. Additionally, the EU is trying to implement a broader ban on short-selling sovereign debt but that probably won’t be in place for another year.
But banning short-selling is the market equivalent of shooting the messenger. Sure, it’s nice not to hear the bad news for a little while longer, but perhaps having gotten the note sooner could have made the defeat a little less bloody.
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