As Investors Scramble, Signs of European Mending Overlooked

As the Dow Jones plunged by record intraday levels last Thursday, investors rushed to pin the blame on European debt woes. Of course, that now familiar culprit was hardly the centerpiece of the tumble likely triggered by glitches between American stock exchanges instead.

That investors were so quick to latch on illustrates the enormous fears surrounding Europe's precarious situation. And the paranoia was on full display again Friday, when American markets tumbled after renewed fears of debt contagion hammered the European financial sector.

Devastating rumors – a fixture of the European saga – ranging from French threats to pullout of the euro to an impending downgrade of the country's debt – also weighed on skittish traders mulling over their risk exposure heading into the weekend. And they seem to have eclipsed promising signs like successful bond auctions by Italy amid signs that the European Central Bank strategy to contain the crisis on the cheap has been remarkably effective.

The latest official cause for panic: deflationary economic data coming out of Spain, leading to angst about the mounting burdens highly leveraged southern European economies would face as the real value of that debt rose.

And yet the news itself should hardly be shocking. With 20% unemployment in the wake of a massive housing collapse, deflation may be painful but also necessary. Price and wage declines, after all, will be necessary to make countries ranging from Spain to Greece competitive on the world stage again.

But fear seemed to be winning the day. "With the Dow off over 200 points today, the psychology of the moment is to once again blame the Europeans for the market's woes," money manager and author Barry Ritholtz wrote on Friday. Rumors that a prominent banking analyst was spreading word of an impending French downgrade were making the rounds on trading desks as well. "These rumors run rampant during dislocations," he noted.

Markets vs. Central Banks

More levelheaded investors, though, may find a much more hopeful picture emerging in Europe. Despite the massive funds at its disposal, the European Central Bank has bought less than 20 billion euros in sovereign bonds so far to ease credit market anxiety and shore up overly indebted countries according to most estimates.

And the results so far have been impressive. Yields for Greek, Portuguese, and Spanish sovereign bonds declined meaningfully. Italy, the most fearsome domino in the so-called PIIGS countries given its size, even sold new bonds at attractive rates on Thursday amid strong demand.

Given the success of the slight intervention, central banks are now backing off, according to reports. And as "the ECB steps away, markets might test their resolve by pushing spreads wider again," Goldman Sachs analysts with a bullish outlook on the European situation wrote. "If that were to happen, we would expect the ECB to let it run for a bit, only to return to punish the shorts."

Indeed, "in the final analysis, markets cannot fight central banks when they have unlimited resources," Goldman analysts wrote. And that lesson may hardly be lost on the short-sellers likely behind the most recent bout of vicious rumors.

A simple back-of-the-envelope calculation, meanwhile, conveys just how much dry powder European authorities have left, the Goldman analysts demonstrate. Suppose that asset purchases come in even at 150 billion euros, 10 times current estimates, and result in steep, highly unlikely losses of 50%. That would come out to "a relatively modest loss of 3.8% of the Eurosystem's balance sheet," they note.

Of course, measures taken to diffuse the debt situation like tax hikes and budget cuts are likely to create additional hurdles to the European recovery that's now materializing. And given the much sharper rebound taking shape on this side of the Atlantic, a tumbling euro is to be expected.

Still, the corrective effect of the sliding currency -- European exports will get a boost, for example -- may be getting overlooked amid the market's latest mood swing. And that goes for a host of other developments to appear in Europe as well.