Yields Flashing Danger Signals

11/23/2011 11:48 am EST

Focus: GLOBAL

Igor Greenwald

Chief Investment Strategist, MLP Profits

The bond market is bracing for something far worse than a run-of-the-mill European recession, writes MoneyShow.com senior editor Igor Greenwald.

The stock market is always the last to know. It’s the Donald Trump of asset classes—a glib self-promoter convinced it runs the show.

Traditionally, it’s paid to pay more mind to the action in currencies and credit. It’s those deeper, “adult" markets that topple governments, shutter banks, and decide when it’s really time to panic. And their message is that we are just about there.

Two bond auctions Tuesday underscored the point. First, Spain could only sell three-month bills at an annual yield of 5.11%—double what it paid a month earlier, and more than no-hoper Greece was charged on a similar maturity just last week.

Meanwhile, the US Treasury auctioned off five-year Treasuries at a record-low yield of 0.94%. Its success is just the flip side of Spain’s woes, as all the money whales flee the European maelstrom for the presumed safety of our shores. The US boasts a workable currency, competent central bank, and an economy presently keeping its head above water, advantages Europe sorely lacks.

The politicians and economists in charge of Germany—and therefore Europe—are wrong on at least three levels, and unaware of the full extent of the destruction they have wrought.

They’re deaf to near-unanimous advice by outsiders to let the European Central Bank cap yields for allies under siege, because they don’t understand that the siege is less about profligacy and more about the economic fallout from the austerity they have demanded.

And Germany has chosen to overlook the fact that its recent prosperity has come at the direct expense of its neighbors, who were gradually rendered uncompetitive by a half-baked currency union, but bribed into acquiescence with cheap loans.

The euro is a millstone dragging Italy and Spain to the bottom. The structural reforms now being offered are far too little, far too late.

Meanwhile, the northern European core that was supposed to rescue the southerners is looking more and more like the next victim. France’s widely doubted AAA rating hangs by a thread, the Dutch economy is shrinking, and Austrian banks have lent a fortune in Italy and Eastern Europe.

Even Germany is feeling insecure. And well it should, with shares of banking giant Commerzbank (CRZBF) dropping 15% on Tuesday, on worries it will need to raise billions to shore up its capital.

Other European banks are busy swapping what assets they can muster to US and UK banks and funds, at an unhealthy discount, in return for other assets that can be used to secure loans from the ECB. The highly leveraged, haphazardly regulated system is on emergency rations, as capital flight forces a credit crunch.

So we have credit markets screaming catastrophe, stocks beginning to roll over, and European policymakers still convinced they’re headed for a “soft patch,” or, at the worst, a mild recession. But if the financial collapse is allowed to run its course, they could find themselves in a far uglier place.

That would inflict more pain on the US economy, which will be facing the headwinds of homegrown austerity next year. Asia is also unlikely to escape unharmed—witness the unwelcome and worrisome drop in a key Chinese manufacturing gauge.

The stock market, hypnotized until recently by the profusion of corporate buybacks, is starting to wake up to the prospect of a 2008-style economic meltdown, focused on Europe but inevitably spreading gloom all over.

Bonds have been signaling something similar for a while. Pray they are wrong.

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