If you've struggled to make sense of the ongoing European debt debacle,
you're not alone. It's difficult even to keep track of all the pieces of this
financial Rube Goldberg puzzle, let alone understand how they can influence one
another.
Though new aspects of the situation seem to crop up every month, here are
some of the most common factors that either reflect or affect sentiment about
what's happening in Europe. Knowing about them might help you understand why
markets react to a seemingly obscure headline. After all, one of the few things
that almost everyone seems to agree on is that the situation isn't likely to be
solved overnight.
Take an interest in interest rates
Interest rates on sovereign debt are perhaps the most closely watched
indicator. When demand for a country's bonds is low because investors are
concerned about the possibility that they might not be repaid in full and on
time, that country must offer a higher interest rate in order to borrow money to
finance its day-to-day operations.
Interest rates become particularly worrisome when they reach or exceed 7%.
That's the level that prompted Greece, Ireland, and Portugal to seek bailouts
from their European peers, and it's widely seen as unsustainable. When a country
must pay that much simply to service its debt, investors become concerned that
high borrowing costs will make a country's financial situation even
worse.
Watch credit ratings
Troubled European countries are struggling to deal with a devilish Catch-22.
In many cases, unsustainable debt burdens have led to stringent austerity
measures; however, such measures also can hamper economic growth, which reduces
tax revenue and can potentially increase deficits. Higher deficits can lead to a
lower credit rating that in turn can mean higher borrowing costs, bringing on
the problems discussed above and potentially launching a new downward economic
cycle. Thus, a downgrade to a country's credit rating tends to raise
concerns.
However, investor reaction also can be unpredictable. For example, Standard
& Poor's January downgrade of nine sovereign nations and the European
Financial Stability Fund was largely met with a shrug by investors. There's been
so much pessimism about Europe for so long that in some cases, markets may
already have priced in much of the bad news.
Monitor credit default swap costs
A credit default swap (CDS) is a form of insurance against the possibility
that a bond issuer might default or fail to make a payment on its obligations.
Bondholders buy a CDS from a financial institution or insurance company that
promises to reimburse the bondholder for any losses sustained in the event of a
default. The cost of that insurance is seen as a proxy for the perceived risk
involved in investing in a particular country's bonds. The higher the cost of a
CDS on, say, Italian sovereign debt, the greater the anxiety about whether the
bond issuer will default and the CDS issuer will have to pay.
Follow the money
To prevent credit markets from seizing up, the European Central Bank late
last year provided almost €500 billion in three-year loans to European banks,
making it easier for them to refinance their debt. The level of borrowing at the
ECB is seen as one indicator of how banks are being affected by their holdings
of sovereign debt. The greater the need to borrow from the ECB, the greater the
banks' perceived level of vulnerability.
Bailouts: Nein nein nein?
U.S. voters aren't the only ones who are sensitive about bailouts; so are
Germans. As Europe's most powerful economy and the one with the best credit
rating, Germany is the tentpole upon which European financial stability hangs.
However, by the end of 2011, the German economy had begun to slow. Any
indications that economic pressure could threaten Germany's ability and
willingness to remain strong in its support of the eurozone can spook anxious
investors.
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