Words are no substitute for action

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Friday’s poor session in bonds and the euro was largely a reaction to Thursday’s offering from the European elite, namely that when the going gets tough, the tough get out the pen (to re-write treaties).  The Italian short-end sold off massively, the inverted curve and yield levels looking more and more like a patient that has gone past the point of no return. 

The sense is that we are getting closer and closer to the inflexion point at which the ECB rolls its sleeves up and gets stuck in – or certain countries are cut loose.  There was also talk on Friday of banks starting to seriously stress-test some of the scenarios that a year ago would have been viewed as ‘black swan’ (high impact, low probability) events. It’s a sign of the position we are in after nearly two years of piecemeal and incremental approaches, based around compromise and national interests.

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Commentary

The increasing euro premium. A sign of the growing nervousness overseas with regards to the eurozone financial sector is the divergence we’ve seen of late between cross-currency basis swaps and Libor-OIS spreads. Both measure, in different ways, counterparty risks. Libor-OIS is the difference between unsecured inter-bank lending and overnight swaps of the same tenor (where principle amounts are not exchanged). Basis swaps measure the premium being paid to access funding in a different currency, again reflecting counterparty risk. On Friday, much was being made  of basis swaps having moved wider again, now through -150bp. But what is also of note is the way they have de-coupled from what we’ve been seeing in Libor-OIS spreads. Previously, they moved much more in tandem, the simple 4wk correlation at around 0.46. That has fallen to around 0.22 as basis swaps have moved wider against a steadier tone to Libor-OIS spreads. The divergence between the two reflects the fact that international lenders – via dollar liquidity – are taking a more cautious view of eurozone creditworthiness than is being seen in the euro interbank markets. We highlighted this last week, but the patterns seen since suggest a more entrenched aversion by those with dollar liquidity to offer. Yesterday’s suggestion of up to 3yr loans from the ECB (currently 1 year is the maximum) is unlikely to offer much respite either, the widening seen in basis swaps probably more based on solvency concerns (via bank exposures to sovereigns) than liquidity issues. This divergence is another factor that is seen pressuring the euro, if sustained.

Europe’s black Friday.  Friday was supposedly the day that US retailers move into profit as US consumers binge on Christmas shopping over the holiday weekend. In Europe, it was ‘Black Friday’ for wholly different reasons. Not only was the single currency under renewed pressure (through the 1.33 level), but there was also pressure at the short end of both the Spanish and Italian yield curves. In Italy yields were up a whopping 50bp to over 7.60% on the 2yr bond, whilst Spain was up a more modest 17bp to 5.77%. Between the 2yr and 10yr maturities, the Italian curve is once again inverted which, historically through the eurozone crisis, has more often than not been a bad omen with regard to more unsustainable funding positions.

Spain pain.  There were reports on Friday that Spain was looking to get outside, taking the window of opportunity after the recent elections to blame it on the previous administration. There were also proposals being floated around regarding the creation of a bad bank, to take on some of the real estate loans that are weighing on the balance sheets of many Spanish lenders. The incoming conservative administration has a majority in parliament, but was seen as thin on concrete proposals to deal with the country’s immediate problems, such as the loan overhang and the cripplingly high level of youth unemployment.

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2 Comments

  1. Good concise resume’.To the point and factual without the doom and gloom and hype spewed out by most media outlets.
    Thank you.

  2. Pingback: Words are no substitute for action | Forex news