From snow in April to a glorious end to May – it is beach season already, although the water remains frigid. The Midwest has dodged the storm season of the South East, thankfully, and our beaches are open. No red flags, yet.
Contrary to my ultra-cautious belief, a red flag does not mean a beach is closed. Per USA Today:
The most serious of all beach warning flags, red flags warn swimmers of serious hazards in the water. One red flag means that the surf is high or there are dangerous currents, or both. Though you can still swim if there is a red flag, you should use extreme caution and go in the water only if you’re a strong swimmer.
Are markets currently showing us a red flag, particularly in Europe?
For a few weeks now the financial press has been focused on an anomaly – the divergence between the bond yield on the US 10 year and the comparable yield on the 10 year German Bund. This has diverged to its widest point since the Berlin Wall fell in 1989. Just recently the US 10 year was at its highest level in 7 years (above 3%) and the German 10 year was hovering around 69 bps. So what is going on here? Is it that investors believe that the ECB has no intention of raising rates for some time to come? Is it that growth prospects for Europe are poorer in the short term?
This academic puzzle was then accentuated by the dramatic shifts in Italian bond yields over the past few trading days and the concomitant move upwards in German bond prices and also safe haven US treasuries. While 10 year US treasury yields fell to well below 3%, the yield on the German 10 year moved as low as 0.2%. As an indicator of the stress that the Eurozone is facing, the gulf between Italian bond yields and German of the same duration is 2.75%, the widest since 2013. So as the US yield curve continues to flatten (with the ominous indications that that portends), familiar anxieties and even panic regarding fracturing in the Eurozone are raising their heads again. This seems odd. The turmoil in Italian politics is neither new nor rare. Growth figures had actually been ticking upwards in recent months, particularly in the beleaguered peripheral economies and the harsh medicine of austerity taken in areas such as Spain and Ireland seemed to be reaping dividends. Spanish bonds have been relatively resilient in the face of the Italian sell-off and although the rhetoric speaks of Eurozone break-up, we are a far cry from where we sat 5 years ago.
So maybe the next few months will be tumultuous in Europe – maybe the waters will be hazardous and most swimmers (investors) should steer clear. There are dangerous currents, to be sure, but the current Eurozone panic may well be a storm in a teacup.