sovereign stress and banks

The translation of sovereign stresses to "real" economic damage happens via banks. There's ample evidence that this process has been underway. Stress in peripheral European countries will be transmitted and amplified via the banks. Broadly speaking, a lack of trust has stopped banks from lending to each other. The ECB is providing liquidity which banks used to provide to each other. The situation is so serious that were the ECB to stop lending to Greece, first the country's banking system and then the European and global banks would fall in the absence of credible core country guarantees.

As Tracy Alloway put it:

Stay short the Euro. One day the market will wake up and realise that repoing €300bn of bonds with peripheral Europe (rising to a lot more, owing to deposit flight) lowers the quality of the ECB balance sheet (surely the domestic collateral is inadequate). Furthermore, we struggle to see how European rates rise as much as the forward curve (june futures for 2012 looking at 3/4% hike from here) when wage growth is just 1.4% and 90% of Spain and Portuguese mortgages are floating cf to 20% in Germany·

Markets have also not realized in my opinion the degree of wage deflation required in peripheral Europe to restore competitiveness. I recommend staying short peripheral Europe (stocks, particularly bank stocks) and long risk-free assets (long U.S. government bonds, long German bonds; short peripheral government bonds, gold).