Friday, May 21, 2010

No Meltdown

The Lehmann Letter (SM)

The stock market rose sharply today, providing hope that we will avoid a repeat of 2008's financial meltdown. No meltdown: No recession. Let's hope that we are putting fear to rest.

Here's how the fear works. Greece defaults on its bonds. Western European banks have Greek bonds in their portfolios. Greece's default casts suspicion upon Portuguese, Irish, Italian and Spanish bonds. A flight from sovereign (the government) debt ensues and Portuguese, Irish, Italian and Spanish bonds’ values collapse. This leads to a general collapse in the value of government bonds around the globe.

Some bonds suffer sharp drops in prices. Other bonds escape with only a small decline in value. One way or the other, as bond prices plunge interest rates rise. The sharp rise in interest rates together with the suspicion cast on all banks that hold government debt (i.e. all banks) drastically shrinks lending. Some businesses can't borrow at the higher rates, while other banks stop lending to conserve their capital. Recession ensues.

If investors are convinced, as they should be, that Europe will avoid what happened to the United States in 2008. Stay tuned.

© 2010 Michael B. Lehmann

No comments: