Euro Area to US Contagion?

I was wondering why the Reuters website wasn’t loading on my computer. Then I got a phone call from a reporter asking about the US stock market meltdown in response to Greece…which struck me as an odd linkage. It still strikes me as an odd linkage.


Here is a graph of the intraday movement in the SP500:


sp500_6may10.gif

finance.google.com accessed at 3:25 Eastern.

I understand that European stock markets should experience re-pricing in response to the uncertainty surrounding sovereign debt. Higher interest rates should induce lower equity prices, in line with standard asset pricing models (simplified example here). In addition, I know there’s a lot of academic research documenting the linkages between stock markets (see Engle, Ito and Lin (Econometrica, 1990) on “meteor showers and heat waves”).


Nonetheless, the sharp downward spike in US equity indices, and then upward rebound, doesn’t make sense. In addition, with the flight to safety in US Treasuries, you’d think that the US equity market would have enjoyed support.


Here’s a choice quote from Bloomberg:

“It’s panic selling,” said Burt White, chief investment officer at LPL Financial in Boston, which oversees $379 billion. “There’s concern that the European situation might cool down global growth and freeze the credit markets.”

So maybe the explanation is in the word “panic”.


On the other hand, a downward revision in the level of US equity prices (but not necessarily as big 9% as in one point for the Nasdaq), does seem reasonable. Higher interest rates and higher uncertainty, slower — if not stagnant — GDP growth, are all negatives for the US. We should expect some impact. How much? Some of the answers are in this paper (coauthored with Kristin Forbes), in which we identify the determinants of the linkages between financial asset markets.


Update, 1pm Pacific: Reuters presents some “instant views”. This quote resonates:

DAVID ADER, HEAD OF GOVERNMENT BOND STRATEGY AT CRT CAPITAL GROUP IN STAMFORD, CONNECTICUT


“Electronic systems are down. It’s complete panic because you’re getting these violent moves, extremely poor liquidity not very good prints on the screens because of all the electronic issues that are going forth, presumably because things are changing so much.


“As we see now the Dow break at one point under 10,000 you trigger a lot of the types of buying programs and other shifts in allocations that they wreak of panic.


It’s no longer a fundamental story. We can’t talk about value…we’re talking about position. And here what you’re seeing and I think we’ve seen it in Europe is simply the pain trade, ‘I’m long stocks, get me out at any cost.'”


“Levels are not important. Prices are not important. Liquidity is as much a victim, I think, as anyone’s, my in particular, portfolio.


“There has been no news this afternoon, the type of thing that would normally you would say this justifies the price action…It’s positions being forced out, prices driving those position shifts, forcing people’s hands. And, a problem with systems in general. I think that comes into play. Put it all together, that’s what’s going on.”

Update, 2:50pm Pacific: Jeff Frankel weighs in on the stock market plunge.

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26 thoughts on “Euro Area to US Contagion?

  1. Ironman

    There’s no linkage. The intraday plunge seems to have been the result of a typo, where someone typed “billions” instead of “millions.” Seriously. I can’t make stuff like that up!
    As for stocks being down otherwise, well, there are fundamental reasons for that, but what’s happening in Greece, while contributing to the noise that affects stock prices in the very short term, will not have a sustained impact.

  2. Allen

    If we assume, “There’s concern that the European situation might cool down global growth and freeze the credit markets.” then it’s not really panic selling, is it? It’s really more of the mark saying, “this increased uncertainty isn’t worth being in the game at X price.” How much did the uncertainty increase? We don’t know because different people are going to be measuring that increase differently.

  3. Unknown

    I can believe that the sp500 lost 9% for some erroneous trades but i can’t believe the currency market dip in the same fashion, moving by i don’t know how many standard deviation???
    EurYen -7.05% ??
    BY the way i am in switzerland and internet was not working to me either. There were disruption on the network somehow.

  4. Mike Laird

    This 2 hour stretch will be analyzed many ways, but I think you are right to focus on the Treasury market. My reading of that market is that it slipped sharply south before (by 30 to 45 minutes – and that’s an eternity) the equity markets. Treasuries have had a huge short position in the past few days by inflation bugs who figured rates would rise and bond prices would fall. Bond prices have continued to rise recently putting the short holders into increasingly negative territory, and IMO, we saw a classic short squeeze in bonds as big positions were closed quickly by buying bonds to cover – which drove bond prices sharply up-interest rates sharply down. With the general uncertainties in all markets, that spooked the equities market. Only a handful of traders on big desks know what really happened, but I think you are correct to sense the smell of bonds.

  5. Frank the salesforecaster

    I think the linkage is about weak dollar driven sales and income growth versus strong dollar driven sales and income declines. Also I think today’s meltdown was strongly affected by a glitch in transaction reporting. Check out the days’ range for PG. I don’t think PG actually traded between $39.37 and $62.67 today with a close at $60.75. Bad trade reporting seems to be the real underlying cause.

  6. jult52

    A reduction to the European bank capital base due to sovereign debt write-downs would reduce the amount of global liquidity, reducing asset prices across different markets. That’s for starters.

  7. Cedric Regula

    It was the Microsoft Office Paper Clip Guy that went on strike out of sympathy for his Greek compatriots. This caused a Wall Street trader to mis-enter an unchecked sell order.
    Everything will be ok tomorrow.
    P.S. Too bad about those stop loss triggers.

  8. GNP

    There were some great opportunities for the nimble and brave in the stock markets today! Didn’t Spain just sell some 5-year bonds at a little over 3 1/2% yields? Why the general panic? Is this just “fat fingers” trading or am I missing something?

  9. don

    In my opinion, it is the revelation that borrowing has limits, and that taxpayers will not cover all loans, even those to sovereign borrowers. Properly valued, I think the financial sector is still under water, and that their return to nearly 40% of total corporate profits is simply a lie. I also think assets values (equites as well as housing) are still inflated. Current stock prices may be reasonable if low real interest rates continued indefinitely, but they probably will not. The future earnings should be discounted at expected future interest rates. These are longer term issues, but markets are supposed to capitalize immediately an expected change in long run prospects. I think they are just coming to their senses.

  10. Artur

    Some sources suggest the link between the PG trade and its presence in the Dow average, they say it could have been a fat finger error trade but im not sure how could an order for a billion shares be processed, seems like a tech glitch.

  11. ppcm

    This subject and its ancillaries were already brought up by Econbrowser (see here) for the most recent “Reminbising China’s Assets” and the major changes in the Vatican forex exposure,and (why) “Adam is eating the apple”,”follow the money”.
    Markets are precise looking forward machines.The Greece country risk was on their agenda since at least 1995 see hereunder link:
    Evolution of the Hellenic government debt and the spread of Greek public debt bonds versus Euro (Germany France Austria).
    http://www.mof-glk.gr/en/publications/debt/bulletin15en.pdf
    http://www.ecb.int/press/key/date/2010/html/sp100415_1_annex.en.pdf?60badb733409c42146d5e127e6389064
    Not to forget either, that a security is as strong as the weakest of its components (euro)
    In essence the financial assets paper inflation versus corporate bonds is overwhelming and liquidities have been a new found issue since 2007.
    A reprieve was given to the financial markets and one may expect that by now all remedies have been taken by ways of capital increase and stabilization of long term funding requirements. If not, let us hear the laments of the Cassandra and watch the Prima Dona of the markets forecast!

  12. Josh Stern

    One principle I follow is that whatever the relative contribution of fundamentals to explaining movements in equity prices, the explanatory role should be greater over longer time periods. In this case, U.S. equity markets, particularly small cap stocks were particularly ebullient in March-April 2010. For instance, even though the Russell 2000 is down almost 10% from its close on April 23, it is still near the level it generally traded at through the middle of March. In contrast, many (most?) emerging market equities benchmarks (e.g. EEM) have fallen back to levels that were common in mid Sept. 2009, while benchmarks that include mainly large European companies are back to August 2009 levels. So if your thesis is that the U.S. should be performing as a safe haven, the equity markets are more or less agreeing with you on a longer time scale.

  13. Anonymous

    The Brown-Kaufman Proposal to break up the largest banks was being voted on in the Senate. Do you think the HFT manipulators may have been sending a less than sublime message to these Senators?

  14. RicardoZ

    Menzie,
    Good post!
    I do believe it was all of the above, closer to the “perfect storm” analogy. With all of the other causes I haven’t see much discussion of the Chinese real estate problems and the announcement yesterday. http://www.businessweek.com/news/2010-05-06/china-s-stocks-plunge-to-eight-month-low-on-property-curbs.html
    What we have is the expanding reach of government into production and services taking businesses off of the tax rolls. There is a narrowing of the tax base so that a small decline can have a huge effect on profit and taxes both in Greece and in the US. The “solution” to the crisis in Greece is just kicking the can down the road only to have to deal with a bigger can later. World wide loss of confidence in government in general as evidenced by the UK voters not giving any party a ruling majority, US primaries both Democrat and Republican seeing incumbents win by the narrowest of margins or losing outright.
    The markets are very fragile.

  15. kharris

    As I understand what I read here, most of the effort is to think of links in the real economy between Greece and the US that would account for stock market swings, as well as swings in other markets.
    Um, we already knew all the news about Greece except for maybe a tiny little bit, what with the Trichet tacitly saying “what about Greece?” during his press conference. So even if linkages were strong, looking to Greece for an explanation would be a dubious exercise.
    Look to risk and volatility linkages between markets, and you may have better luck. For ever so long now, the word “risk” has been tossed around in financial commentary, to the point it is becoming a nonsense word. The yen is a carry-trade currency, with risker assets financed by borrowing in yen. Anytime there is a perception that risky trades may go bad, the yen goes up – even if there has not yet been time to unwind carry trades. Same with Treasuries and stocks. You all know that dance.
    Look at Brl and Mxn yesterday, as opposed to Clp. Two big, happy emerging market risk trades and one graduate looking to join the G20. Brl and Mxn took a serious drubbing – because of fundamental linkages to Greece? Nopes. Because of how they are defined in various trading algorithms. When the S&P fell by a certain amount, it was time to dump Brl and Mxn. It was probably no more complicated than that.

  16. kharris

    By the way, Menzie’s post does offer one important bit of information. A financial reporter called and asked to have a causal link between a news headline and a market reaction validated. That is the cookie-cutter financial reporter approach. It comes in two parts. One is the notion – probably the result of orders from on high regarding how to write market stories – that some reportable event is necessarily the cause of a market price change. The other is that they need somebody in a position that lends credibility to the linkage to describe the linkage in a quotable way.
    So we have a financial press that constantly reinforces a view of how things work, that may often have nothing to do with how things are working.
    When I get those calls, I tell them “no”. At one time, I would try to offer alternative explanations, but that never seemed to change the outcome. They’d just find somebody else to quote.

  17. spencer

    While fundamental usually only play a very minor role in big one day market moves like this,
    I personally think the major market risk is deflation, not inflation and the problems in Greece and other European debtor nations will make a significant contribution to world deflationary pressures.

  18. tj

    Technical glitch aside, the U.S. should benefit from sovereign debt issues around the world. Capital flight to the U.S. will cause the dollar to appreciate and treasury rates to fall. As bad as our debt problem is, we are better off than most other (liquid) safe havens. Our day of reckoning is far enough down the road that U.S. securities markets are still a sound option during a period in which the world is placing more weight on tail event scenarios.

  19. jyl

    1. Strong market perf YTD, so substantial profits to lock in.
    2. Valuations extended for some sectors that led rally, fundtls not yet accelerating for sectors that lagged rally.
    3. Earnings reports largely done, fewer positive catalysts to look forward to over next few weeks.
    4. Its May, when you sell and go away.
    5. So equity investors looking for reason to cut weight and take a breather. Greece and bond market action is a reason. Bizarre trading Thu w/ no quick explanation on Fri is another.
    Step aside, let market test technical support, see if it holds. That’s what I’m seeing.

  20. Cedric Regula

    Rumors are going around that it may NOT have been the Microsoft Office Paper Clip Guy. Even Pisani at CNBC voiced some doubts over his fat finger reporting yesterday.
    The NYSE circuit breakers took the exchange off-line for 90 seconds. The rest of the exchanges don’t do that. They are now trying to figure out if that like a big truck slamming its brakes on while driving down the freeway.
    High Frequency Trading is under suspicion again. Maybe the unhappy algos kicked in instead of the DOW 36000 subroutine?
    Analysis so far indicates most of the bad trades were ETFs, and these have been a favorite vehicle of the Algo guys.
    Also, some think that Goldman gave their Supercomputer the day off on Thursday. This liquidity provider was sorely missed, and still hasn’t returned from the Hamptons.
    Rumors also abound about the CB meeting about Greece this weekend. Ben may re-open swap lines to the ECB. The ECB may decide to bail out all Euro banks. The Dollar Index is not sure what to make of this. It was 82.5 on Tuesday, ramped to 85.5 thru Friday, then in the last hour dropped a penny on CB meeting speculation.

  21. Cedric Regula

    Here’s the details on bank exposure to the PIIGS. This is direct exposure and only 1.57% of US banking assets are there. But we’ve learned how interconnected banks and markets are…
    Nations’ Banking Systems Most Exposed to PIIGS Nations
    Portugal
    Banking Sector Asset Exposure: 14.08%
    Total PIIGS Exposure: $64.54 billion
    Size of Financial System: $458.38 billion
    Direct Banking Sector PIIGS Exposure
    Portugal: N/A
    Ireland: $21.52 billion
    Italy: $5.20 billion
    Greece: $9.75 billion
    Ireland
    Banking Sector Asset Exposure: 13.5%
    Total PIIGS Exposure: $90.378 billion
    Size of Financial System: $671.45 billion
    Direct Banking Sector PIIGS Exposure
    Portugal: $5.43 billion
    Ireland: N/A
    Italy: $46.26 billion
    Greece: $8.46 billion
    France
    Banking Sector Asset Exposure: 10.4%
    Total PIIGS Exposure: $911.32 billion
    Size of Financial System: $8.76 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $44.74 billion
    Ireland: $60.33 billion
    Italy: $511.45 billion
    Greece: $75.17 billion
    Belgium
    Banking Sector Asset Exposure: 7.93%
    Total PIIGS Exposure: $118.89 billion
    Size of Financial Sector: $1.498 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $3.12 billion
    Ireland: $60.77 billion
    Italy: $29.86 billion
    Greece: $3.62 billion
    Netherlands
    Banking Sector Asset Exposure: 6.79%
    Total PIIGS Exposure: $243.59 billion
    Size of Financial System: $3.585 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $12.41 billion
    Ireland: $30.82 billion
    Italy: $68.73 billion
    Greece: $11.89 billion
    Germany
    Banking Sector Asset Exposure: 6.18%
    Total PIIGS Exposure: $703.795 billion
    Size of Financial Sector: $11.3803 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $47.38 billion
    Ireland: $183.76 billion
    Italy: $189.68 billion
    Greece: $45 billion
    Japan
    Banking Sector Asset Exposure: 5.02%
    Total PIIGS Exposure: $121.87 billion
    Size of Financial System: $2.424 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $4.22 billion
    Ireland: $30.19 billion
    Italy: $53.08 billion
    Greece: $6.39 billion
    Austria
    Banking Sector Asset Exposure: 4.84%
    Total PIIGS Exposure: $50.15 billion
    Size of Financial Sector: $1.035 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $2.79 billion
    Ireland: $8.49 billion
    Italy: $25.39 billion
    Greece: $4.65 billion
    United Kingdom
    Banking Sector Asset Exposure: 4.53%
    Total PIIGS Exposure: $417.86 billion
    Size of Financial Sector: $9.223 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $24.26 billion
    Ireland: $187.51 billion
    Italy: $76.87 billion
    Greece: $15.09 billion
    Spain
    Banking Sector Asset Exposure: 3.65%
    Total PIIGS Exposure: $149.8 billion
    Size of Financial System: $4.101 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $86.08 billion
    Ireland: $15.66 billion
    Italy: $46.79 billion
    Greece: $1.27 billion
    Denmark
    Banking Sector Asset Exposure: 2.39%
    Total PIIGS Exposure: $24.04 billion
    Size of Financial System: $1.004 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $283 million
    Ireland: $20.75 billion
    Italy: $513 million
    Greece: $182 million
    Chinese Taipei (Taiwan)
    Banking Sector Asset Exposure: 2.32%
    Total PIIGS Exposure: $4.32 billion
    Size of Financial System: $185.59 billion
    Direct Banking Sector PIIGS Exposure
    Portugal: $45 million
    Ireland: $3.77 billion
    Italy: $243 million
    Greece: $71 million
    Spain: $192 million
    Switzerland
    Banking Sector Asset Exposure: 2.05%
    Total PIIGS Exposure: $58.687 billion
    Size of Financial System: $2.855 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $3.86 billion
    Ireland: $16.53 billion
    Italy: $16.39 billion
    Greece: $3.64 billion
    Italy
    Banking Sector Asset Exposure: 1.93%
    Total PIIGS Exposure: $63.12 billion
    Size of Financial System: $3.26 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $6.74 billion
    Ireland: $18.35 billion
    Italy: N/A
    Greece: $6.92 billion
    United States
    Banking Sector Asset Exposure: 1.57%
    Total PIIGS Exposure: $186.69
    Size of Financial Sector: $11.827 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $4.99 billion
    Ireland: $58.55 billion
    Italy: $53.79 billion
    Greece: $16.65 billion
    Sweden
    Banking Sector Asset Exposure: 0.983%
    Total PIIGS Exposure: $14.29 billion
    Size of Financial System: $1.454 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $469 million
    Ireland: $4.686 billion
    Italy: $2.602 billion
    Greece: $684 million
    Turkey
    Banking Sector Asset Exposure: 0.22%
    Total PIIGS Exposure: $1.2 billion
    Size of Financial Sector: $541 billion
    Direct Banking Sector PIIGS Exposure
    Portugal: $2 million
    Ireland: $111 million
    Italy: $630 million
    Greece: $388 million
    Greece
    Banking Sector Asset Exposure: 0.2%
    Total PIIGS Exposure: $1.36 billion
    Size of Financial Sector: $456.39 billion
    Direct Banking Sector PIIGS Exposure
    Portugal: $105 million
    Ireland: $804 million
    Italy: $13 million
    Greece: N/A
    Brazil
    Banking Sector Asset Exposure: 0.198%
    Total PIIGS Exposure: $3.11 billion
    Size of Financial System: $1.57 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $1.13 billion
    Ireland: $49 million
    Italy: $454 million
    Greece: $5 million
    Australia
    Banking Sector Asset Exposure: .08%
    Total PIIGS Exposure: $1.73 billion
    Size of Financial Sector: $2.150 trillion
    Direct Banking Sector PIIGS Exposure
    Portugal: $108 million
    Ireland: N/A
    Italy: N/A
    Greece: $28 million
    Source:
    http://www.cnbc.com/id/37025018?slide=1

  22. Anonymous

    I called this months ago (longer than these examples).
    “Mar 08, 2010 Sell or sell short at the end of April”
    3/19/10 “Market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from apr to may. That is a big one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down”
    4/29/10 “Looking @ Wed. the 5th for pivot”
    5/02/10 “I would rather be “short” than “long”, or even completely “out”, on Monday. That will be the first day I will look to short”
    5/03/10 “The markets usually turn (pivot) on May 5th (+ or – 1 day)”
    As for Greece, as always, when the US sneezes, the World catches a cold. Greece was already a problem. The FED just exacerbated their liquidity/solvency problem, just like Oct 19, 1987, just like Feb 27, 2007, etc.
    I.e., this sudden downdraft was simply Bernanke’s monetary mismanagement.
    Economic forecasts are infallable.

  23. Eric

    This is the ‘new normal’ of market forces. When low volume markets view common issues we get a ‘6 sigma’ event.
    Innovation has far outpaced regulation.

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