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Bonds in Europe are in a death spiral and the European banks are along for the ride. The weakening economy in Europe has raised the likelihood of default for nations like Portugal, Italy, Greece and Ireland. And the increased potential for default has raised the interest rate on bonds.
The despair in Europe is well chronicled. I don't need to tell you the entire region is screwed up. Higher interest rates on bonds have made repayment more difficult and since repayment is more difficult the interest demanded by investors on bonds has also increased. It's a nasty spiral.
All year you have heard about a likely Greece default. And considering the yield on bonds is still over 32%, investors clearly believe Greece will still default.
A 32% interest rate is unheard of in a normal market. But as many investors and traders understand, the market today is far from normal.
Of course, Greece wasn't the only country on the brink of collapse in 2011. Later in the year we found out that Italy is in terrible shape too. While Italy is not nearly as financially troubled as Greece, investors fled the market and bank stocks collapsed when the 10 year Italian bond yield moved above 7% in November.
Higher interest rates are almost always bad for the market. A higher rate results in a higher cost to borrow. And when a country is on the verge of default, higher interest payments will not promote a badly needed economic recovery.
The effect of an increase in bond interest rates is not limited to the interest paid. Bond yields and bond prices move inverse to each other – when yields go up, prices go down.
Last month, when bond yields climbed higher, the price of European bonds declined which lowered the value for the bonds current owners. Banks, specifically European banks, possess millions of euro worth of bonds. And as bond prices moved lower, the investments held by those banks moved lower too.
The interest rate death spiral is out of control. And anyone tied to it (all European banks) will be beaten down and leveled.
All European banks are in danger, but as an American investor it can be hard to trade against those banks because many do not trade on our exchanges. Additionally, exposing yourself to shorting one individual bank is highly risky.
This video takes you through the chart of the iShares MSCI Europe Financials Index (Nasdaq: EUFN). The EUFN is comprised of nearly all the big European banks (even the ones that do not have access to American exchanges).
This video analyzes the chart of the EUFN ETF. You'll get specific prices to watch if you decide to enter a bearish trade against the European banking sector.
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Jason Cimpl
Editor, TradeMaster Daily Stock Alerts
Washington, DC
Editor's Note: Jason's trading service, TradeMaster Daily Stock Alerts, is having another banner year 108.4% total gains in January…97.7% total gains in April…41% total gains in September…89.2% total gains in October. Use this link to start today.