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By Rom Badilla, CFA – Bond Trader and BondSquawker

Something does not feel right with the markets.

The Greek crisis continues to deteriorate.  For all intents and purposes, the country is shut off from the capital markets and must resort to relying on aid from fellow European members and the IMF to finance debt that is coming due in Mid-May.  Civil unrest continues as workers protest the latest cuts in benefits and shortly after Greek Premier, George Papandreou officially activated the request for aid.

The dollar continues to rally while the Euro falls day after day.  The price for Gold has increased as investors seek a safe-haven from risk of sovereign default.

Several weeks ago, I drew comparisons of Greece with the Mortgage Market Meltdown from the first half of 2007.  Mortgage Backed Securities, which spearheaded the debt-driven economic boom, were collapsing while stocks maintained their lofty valuations.

Earlier this week, Bondsquawk compared charts of Credit Default Swaps between Lehman Brothers before declaring bankruptcy in 2008 to today’s Greek CDS spreads.

Deutsche Bank recently stated that the financial markets could face the risk of seizure similar to when Lehman Brothers went bankrupt if Greece ends up restructuring its debt.

Yet, the U.S. equity markets continue to grind higher and higher as people are convinced that the economic recovery fueled by debt-driven stimulus, is underway.  Greece in the minds of many, is too small to have an effect apparently, judging by last week’s price action with the S&P 500 closing out the week at a high of 1217.28.

(S&P500 Index versus Greece, Spain, & Portugal CDS Spreads)

Unfortunately, exposure to Greece is all throughout Europe and the market perception in the U.S. is not recognizing the events happening abroad.

According to Citigroup, 80 percent of Greek debt claims are on European balance sheets which are led by banks from France (25 percent), Switzerland (20 percent) and Germany (15 percent).

The fallout is now spreading to other countries like Spain, Portugal, and Italy as debt spreads are increasing as well.  Signs of contagion are apparent as peripheral countries witnessed their bond yields and CDS spreads widen with the deterioration of Greece.

What is troubling is that Spain and Portugal comprise a large portion of CDS outstanding.  According to the Depository Trust and Clearing Corporation (DTCC), sovereigns including Spain (15.2%), Greece (8.8%), and Portugal (9.6%) are among the largest reference entities for CDS outstanding.

According to Morgan Stanley, the risk for contagion is high as the countries are linked.  32 percent of Spain’s debt is owned by German banks while 25 percent is owned by French banks.  In addition, 51 percent of Portugal’s debt is owned by Spanish banks. Therefore, problems in Portugal debt could easily spillover to the strongest economies.

Other countries dependent on the IMF will be hurt if IMF has to act beyond Greece.  If Spain, which is four times the size of Greece in GDP terms, follows suit for example, the IMF could be encumbered in reacting to other crisis around the globe as it will have used up too much of its remaining capital.

Even if we assume that there is some resolution to Europe’s debt problems, this much is certain.  Tough spending cuts and austerity measures will slow growth and increase downside risk to European equities which could push U.S. stocks over an edge.  The Fed and ECB would be handicapped for the remainder of the year in terms of tightening monetary policy which would hold front end interest rates. Furthermore, the longer end of the U.S. curve could rally from deflationary pressures and prospects for slowing growth.

While this gloomy scenario would put stocks more in line with bonds, market sentiment unfortunately, would be far from feeling “right”.

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