Fears about a euro break-up is at fever pitch in the bond market, but markets elsewhere seem almost nonchalant to the potentially explosive impact of such a "tail" risk event. The yield on 10-year Italian government bonds spiked above 7 percent in the past week, a level where the cost of financing a debt burden of nearly 2 trillion euros is seen as unsustainable.
Talk of discussions which could lead to a smaller eurozone triggered a rush to the safest havens, prompting investors to sell off French debt which pushed the French/German 10-year yield spread to a euro-era high.
Many reckon that a euro breakup would trigger market turmoil similar to or worse than was felt after the collapse of Lehman Brothers in 2008, prompting a run on banks and causing a global depression. Despite these frantic moves in the immediately affected markets, however, there was no sharp sell-off in other asset classes.
World stocks, measured by MSCI have lost 2.7 percent this month, but remain 13 percent above their 15-month trough hit in October. Oil prices - sensitive to global growth expectations - hit a two-month high above $116 a barrel in the past week, with year-to-date gains of nearly 20 percent. So which side is wrong here? "Between risky markets and defensive assets, one is being too optimistic and the other is being too pessimistic. The truth lies somewhere in between," said Eric Siegloff, global head of strategy and tactical asset allocation at ING Investment Management.
"What we're talking about (a euro break up) is a tail risk. When you look at a tail risk, the probability of that occurring is less than 5 percent. You should have some protection for the 5 percent probability, but you also have to make sure your portfolio lives. As an asset manager, you've made commitment to outperform benchmark."
There is also a difficulty in pricing in a tail risk event. Most asset managers, in the run up to the deadline of US debt ceiling debate in August, faced the threat of a US default risk - which was considered a tail risk - without concrete contingency plans.
"We don't know what a euro break-up means. It's not been done before. There's no examination of history, links to banks or lending. You can't price in because there's no bottom. Who wants to catch a falling knife?" Siegloff added. The key test for investors in the coming week includes the 3 billion euro auction of five-year Italian government bonds.
Italy, which has overtaken Greece as the main focus of investor concern, was forced to pay a 6.087 percent yield, the highest in 14 years, at a one-year debt auction on Thursday to place the full planned amount of 5 billion euros.
While equities are not pricing in a global depression, higher than average volatility makes it expensive to put on tail risk hedges.
For example, implied volatility for Euro STOXX 50 index stands at above 42 percent, above the 200-day moving average.
"The implied volatility is very high and tail risk hedges are not cheap now. Quite often the best time to do it is when everything looks good," said Patrick Armstrong, fund manager at Distinction Asset Management.
"I would rather own Italian bonds than short equities. Equities are pricing in recession, but not a depression. They are trading below book value, the euro zone as a whole, ex banks. They are cheap valuations compared with historical multiples."
Armstrong still has a defensive portfolio - he allocates 35 percent in cash, focuses on defensive equity sectors such as healthcare and telecom, and shorts Russell 2000 index - a cyclical, small-cap focused measure exposed to US growth.
The disconnect between the euro debt market and elsewhere in approach to the tail risk may also stem from the difference in the return metrics between equities and bonds.
"The payoff mechanism is different - equities have unlimited upside. Bonds are capped upside but potential downside of default," he added. This may be making bond investors inherently paranoid.
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