How to Know When the Euro Crisis Reaches a Tipping Point

Two huge financial dangers that still seemed somewhat unlikely a few months ago now appear hard to avoid. First, the common euro currency is in deep trouble, and European governments are frantically trying to save it. Second, the chances of a worldwide recession are increasing because of these attempts to stave off the euro’s collapse. Although the problems have been going on for some time, they’re about to get much worse. To know when the crisis is reaching a tipping point, keep your eye on global government bond yields.

Although European leaders are still behaving as though the euro can be saved, behind the scenes banks are preparing for the breakup of the Eurozone. One of the effects of what the banks are doing is that global bond yields are diverging. Where banks cut back their bond holdings, countries have to pay higher yields. By contrast, in those countries where banks are willing to park their money for safekeeping, governments don’t have to pay very high yields.

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A second effect of banks hunkering down is that they become less willing to lend money. To support a loan portfolio of a given size, banks have to have a certain amount of equity. If losses on government bonds eat into that equity, banks have to raise more capital. This undermines their stock if they sell additional shares to raise cash while share prices are depressed.

But banks have an alternative. Instead of building their equity back up to match the scale of their lending, they can instead shrink their loan portfolio down to the level their existing equity can support. Banks do this by refusing to make new loans as old loans come due. The result is a credit squeeze that can cause or at least worsen a recession.

You can see how much trouble countries are in and how much pressure banks are under simply by looking at bond yields, which you can think of as a measure of how much investors feel they need to be paid to justify the risk that they won’t get some or all of their money back. As a general rule, countries are in very serious trouble when yields on 10-year bonds go above 7%. In Greece, the weakest country in the Eurozone, bond yields are off the charts. In Italy, yields have risen as high as 7.8%. In Portugal, they have reached 12.6% and in Belgium 5.8%. French yields have climbed above 3.5%, which may not sound so bad but is still a lot higher than the yields in countries regarded as safe.

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Indeed, countries outside of the Eurozone are benefiting as investors look for safe havens. In the U.S., 10-year yields are 2%; in the U.K., 2.3%; and in Japan, just over 1%. These three countries all have big debt problems of their own. Nonetheless, their yields remain low, not because investors are confident about the long-term outlook, but because they are looking for short-term places to park money away from the Eurozone.

Germany is the most interesting case. Yields there have remained relatively low, around 2.3%, even though the country is in the Eurozone. Up until recently, though, investors had been confident that Germany would remain rock solid financially. Moreover, they believed that if the euro does collapse, German investments would probably appreciate in value once the drag of weaker countries was gone. But last week’s disappointing bond auction shows that even Germany is not immune to Eurozone problems.

Investors therefore face two unpleasant possibilities. The first is a collapse of the euro at some point – quite possibility within the next few months – accompanied by bond defaults that send a shockwave through the global banking system. The short-term effect would likely be a drop in the U.S. stock market below its 2010 bottom of 9,686 on the Dow. But since U.S. companies are in better shape than they were early in the recession, it seems unlikely that the Dow would go as low as its 2009 bottom of 6,626.

The other possibility is that repeated attempts to shore up the euro prevent a crash but promote a new recession, a so-called double-dip. Forecasters are now predicting that the U.K. will slip back into recession in 2012. And some investment strategists think a U.S. recession is now more likely than not.

You can track the changing level of these global financial risks by watching what happens to government bonds yields. As long as 10-year Italian bonds have to continue paying more than 7%, the Eurozone is in serious trouble. If Spanish or Belgian bonds rise to that level, the crisis would worsen significantly. And further increases in French bond yields could signal the beginning of the end – Germany and the Netherlands can’t support the Eurozone if France is in serious trouble.

There’s not a lot you can do in the face of these risks beyond staying defensive and keeping part of your investment portfolio in cash. If there is a short-term market plunge, you’ll certainly be able to use any extra cash to scoop up stocks and income-oriented funds that are great bargains.