Imagine a postcard-perfect mountain village. A-frame chateaus, old world door crests, cheery gas lamps – the kind of place you might see tucked away in the Pyrenees or the Swiss Alps. As a crowning touch, large flakes of snow are gently falling.

Now take a step back. Instead of an actual village, you are looking at the contents of a snow globe.

The snow globe is sitting on the edge of a large oak table.

Now you see the back of a large, well-manicured hand – perhaps a banker’s hand – accidentally sweep the snow globe over the edge of the table. The snow globe hurtles toward the cold marble floor, where it will shatter into a thousand pieces.

What you have just envisioned is a metaphor (or is it analogy, I forget) for Europe. The free fall is happening as I write.

The Horror

If Colonel Kurtz had been a European banker (rather than a deranged flyboy lost deep in the Congo), he would know exactly what to say about Europe’s fiscal predicament now:

“The horror… the horror.”

Here are some choice examples of what I mean:

• According to a recent Bloomberg story, “Germany and France may be forced to contemplate the bailout of entire nations [emphasis mine] rather than just individual banks.” A number of European countries are in the tight spot of hosting banks that are not just too big to fail, but potentially too big to bail… meaning the extent of bank losses could outweigh the host country’s GDP.
• BCA Research reports that, with Iceland serving as the “gold standard” of credit risk, the five sovereigns closest to an Icelandic fate are all European: Portugal, Ireland, Spain, Italy and the United Kingdom.
• Less than two weeks ago, the UK Telegraph got its hands on a “secret” Brussels document being circulated among high-profile finance ministers. According to the Telegraph, this highly confidential 17-page report suggests toxic asset bailout estimates as high as 16.3 trillion pounds, or more than $23 trillion U.S. That’s trillion with a T… more than the gross domestic product of all European Union countries combined. The estimate could be reduced by three-quarters and it would still be disaster.
• Eastern Europe is enduring its own special circle of forex hell, with the Prague and Warsaw exchanges plumbing multi-year lows. For example, the Polish Zloty has gone into free fall as a result of “toxic FX options” – the currency version of Credit Default Swaps. As the FT Alphaville blog reports, Polish banks flogged these toxic forex derivatives to corporate clients; when the Zloty fell below a certain level, the options triggered a daisy chain of spiraling corporate losses.

The New Odd Couple

The mass carnage unfolding in Europe further explains an extremely odd phenomenon: the bosom-buddy pairing of gold and the dollar.

When new traders get their first taste of the “macro” landscape – You mean this stuff is all connected? Wow! – the gold-dollar relationship is one of the first things they learn about.

Gold and the dollar, in short, are supposed to be like matter and anti-matter. When gold is strong, the dollar is generally weak (and vice versa). A steady-eddie greenback represents the triumph of central bankers and the taming of inflation… where rising gold, in contrast, represents banker’s folly and the ravages of the printing press. They are north and south, black and white, yin and yang – you get the picture.

That long-standing set-up explains why it’s been just plain weird to see gold and the dollar jointly kicking butt as of late. Both are exploring multi-month highs, as if the tandem climb were the most natural thing in the world. (In my latest Macro Trader briefing, I described the yellow metal and the greenback as “The New Odd Couple.”)

So how does this tie back in to Europe?

Simple: With an entire continent choking on the equivalent of toxic subprime squared, there are only three obvious places on Earth left for large pools of terrified financial capital to hide – gold, the U.S. dollar, and U.S. Treasury bonds. (And guess what… two of those three are booby-trapped!)

I’ll admit it. I didn’t foresee Europe getting itself into this much trouble. The “old world” is supposed to be more staid and conservative than the United States – in matters of finance at least – so who’d have thought that nose-in-the-air Brussels types could have layered on enough leverage to make a swaggering Texan blush?
Now What?

So where do we go from here? As I told Macro Trader members more than a week ago, the dollar is a mystery wrapped in a riddle for now. We shifted our trading bias from bearish to neutral on the buck without taking a forex stance either way. There are some currencies we like very much from a longer-term investment perspective, but from a trading perspective it’s watch and wait.

As for gold – which we have been long for weeks in Macro Trader via gold stocks and the metal itself – when the stars align, they really align. I think that’s the case for the yellow metal now.

To borrow a turn of phrase from an old Market Wizards interview, the sun has moved closer to the Earth and gold is the best zinc ointment money can buy. Greenbacks and U.S. treasuries, the second and third best alternatives in a world where Europe and Japan are imploding, offer broad and deep liquidity but make for seriously lousy sunscreen.

As you’d expect, I’ll keep an eye on the Europe situation (as well as the many other crazy developments unfolding right now) and keep you posted.

A few of you have also written in to say “Hey JL, what about all that gold in the vaults of the IMF and Fort Knox? Aren’t you worried they might try to dump it on the market?”

My answer: Nope, not really. Even if the powers-that-be had the stones to try such a maneuver (which I doubt), it would prove to be a suicide move. Next week I’ll tell you why…

Source: Europocalypse

This from Sovereign Society:

Several segments of the credit markets have come back to life in December after crushing losses recorded in September and October. Though it’s too early to celebrate a broad-based credit revival, the largest issuers of investment grade debt surged this month as yields plunged. Mortgage-backed bonds, or agency debt, have also rallied sharply in December on the heels of government guarantees and the Fed’s plan to spend $500 billion dollars to shore up the sector.

With the United States and other governments amassing a truckload of debt to finance state sponsored bailouts of financial services and fiscal spending plans, it is conceivable that investors will increasingly swap low-yielding T-bonds for high quality corporate debt in 2009.

Since hitting a post-crisis peak of 4.88% in October, three-month LIBOR (London Interbank Offered Rate) has plunged to 1.52% on December 19. On December 1, LIBOR stood at 2.22%. A lower LIBOR rate is the first indicator to finally emerge from stress amid the credit crisis. Banks are still largely hoarding cash but several large institutions have started to lend in overnight markets this month for the first time since late 2007.

The Growing Yield Dilemma

The Federal Reserve’s latest interest rate cut to effectively 0% on December 16 has laid the foundations for more trouble at money-market funds where yields for 30-day and 90-day Treasury bills continues to fetch just 0.01% – the lowest in more than six decades. Earlier in December, 30-day bills actually turned negative for the first time since 1940. That means investors are paying the government to park cash.

Money market funds are now sitting on potential losses as management fees erode the yield generated by Treasury bills and other short-term paper. Though other debt securities yield more than T-bills, investors might be embracing more credit risk as fund companies look to boost yield.

A better alternative to money market funds include one-year term deposits (CDs), short-term investment grade bonds and even intermediate-term corporate debt. Term deposits should be held only at the nation’s biggest banks, including J.P. Morgan Chase, Wells Fargo and Bank of America.

Yield Hungry? Here’s a Free Lunch

The Fed’s latest moves to spur lending in a massively credit-inflicted bear market since 2007 is forcing many investors to turn to distressed corporate investment-grade bonds. The effective yield on the benchmark Dow Jones Corporate Bond Index is 7.23%, down from a record high of 8.88% just a few months ago and down from 8.06% on November 30. A lower yield means corporate bond prices are rising in value.

In September, investment grade bonds were hammered following the collapse of Lehman Brothers Holdings and posted their single worst month of performance since February 1981. Many bonds plunged more than 15% in September alone.

More than half of the investment grade bond sector is comprised of financial services debt or bonds issued by some of the largest banks in the United States and Europe. With the Fed’s implicit guarantee on the largest issuers of such debt, investors can now tap into bank issued bonds trading at a 5.16% premium to expensive Treasury bonds.

For a portion of an investor’s liquidity, corporate high quality debt is literally a “free lunch.” The largest issuers of corporate paper have started to return to the market since November, including IBM and other large cap companies. In Europe, some banks without government guarantees have managed to raise sizable offerings – a positive development.

Corporate Debt: The New Safe-Haven?

Since October, governments in the United States and Europe have swapped government paper for toxic mortgage-backed assets previously held at banks. Despite these efforts, most banks are still laced with all sorts of other clogged credits like leverage loans, auction rate securities and repo credits.

The credit crisis has not disappeared because of aggressive government and central bank action; rather, swaths of credit risk has been transferred from bank balance sheets to government balance sheets, effectively polluting central bank coffers with largely illiquid and near worthless paper. Since August, the Fed’s balance sheet has mushroomed from $850 billion dollars to more than $1.5 trillion dollars – and still rising.

Indeed, credit default swap rates since October have risen sharply on government paper while swap rates have decreased for the highest quality companies. This suggests investors are starting to place a risk premium on government issued bonds.

Are we at the cusp of a major transition in the credit markets whereby investors might increasingly purchase investment grade debt as a hedge against rising yields on government bonds? After all, outside of the financial sector many industries harbour their highest net cash levels in more than a decade. For some companies, especially the food and beverages and fast-food companies, cash flow is largely generated internally and, in most cases, these companies don’t need to raise cash to finance operations. I would argue that companies like Kraft Foods (NYSE:KFT), General Mills (NYSE:GIS) and McDonald’s (NYSE:MCD) are a better long-term credit risk than most sovereign borrowers.

Failed Auctions Rising

To confirm the above theory that perhaps investors are starting to embrace riskier bonds like investment grade debt because of bulging government deficits, consider the trend in Europe since October whereby several governments have scrapped bond auctions.

Over the last sixty days, Germany, the Netherlands, Italy, Spain, Austria and the United Kingdom have either scrapped bond auctions or reduced their planned offerings because of tepid investor interest. These governments, including Germany, the largest and most liquid, are paying higher yields to draw institutional buyers. This could mark the beginning of a bear market for government bonds at some point later in 2009, once credit markets stabilize and risk taking is resumed.

In the United States, demand for Treasury’s remains strong because of fears of deflation. The current environment – a disaster for just about every asset class except T-bonds – has supported the dollar to an extent. Foreigners are chasing Treasury securities as they scramble for safe havens. Yet even Treasury is not immune to the deluge of supply coming our way in 2009.

Over the next 12 months Treasury estimates it will have to raise about $1.5 trillion dollars to fund gargantuan fiscal spending plans, bailouts, and possible tax cuts. Treasury will re-introduce one-year, three-year and five-year T-bonds in 2009 to finance part of this spending spree. At some point, investors will force long-term rates higher. The Fed will try to influence the long end of the yield curve but will ultimately be unsuccessful. The Fed can only control short-term lending rates.

Investment grade bonds shouldn’t supplement T-bills. The risk spectrum is normally quite significant in a normal economic environment. Yet these are anything but normal economic times. It is possible that as 2009 progresses and, assuming credit markets continue to grudgingly normalize, the new safe haven in bonds will be high quality investment grade bonds at the expense of super low-yielding Treasury debt.

Source: Is Investment Grade Corporate Debt Safer Than Government Bonds?