We're fools whether we dance or not, so we might as well dance ~ Japanese Proverb

Following last week’s fiscal “lite” agreement in Brussels, markets are behaving like a cat with furballs – lots of coughing, gagging and then when you think something really bad will happen, reverting to a sense of eerie calm. With all the liquidity injected into the system, dealer desks anticipate no major bank default in the horizon. That said, they may be “talking their book” and with the headlines in Europe getting worse by day – punitive yields, substantial near term refinancing walls, political bickering, strikes – there is an impending sense of doom and gloom in this usually festive period.

The arithmetic around Europe is not inspiring. If your debt/GDP ratio is close to 100%, your funding costs are 6% and growth is predicted to be zero, then your debt can only go up – not down. If the markets refuse to lend to you or keep charging higher yields, you eventually go bust. The markets pray for Santa to turn up in the guise of the ECB and buy Euro-zone Bonds in size. This would transform default risk into inflation risk and we should see a spike in nominal value of risk assets. After all, inflation has been the chosen vehicle for solving debt crises of most governments since the early 20^th century, ironically coinciding with when the FED was created in 1913. The question you must ask is if the ECB or indeed the FED will come in with further QE at these market levels. Suspect they will wait for much lower levels and a greater sense of panic before they act.

If you believe we are in strange times so far as Europe is concerned, please see the chart below which shows bond yield spreads of the core Euro countries against Germany. Could it be that period 2000- 2008 was the outlier and these are more normal times?

I must be dreaming for it all looks so different or I have just woken up and everything before was a dream?