Sizing up EuroZone debt and risk spreads

Today we have a look at EuroZone debt spreads and spreads versus US interest rates and try to divine what the market is telling us. The key question here: is the reduction in PIGS spreads what it seems?

(Note all data for this article sourced from Bloomberg). A lot of attention has been showered on the three little PIGs at the EuroZone periphery and their sharply improving fortunes of recent days – at least as measured by their debt spreads versus Germany. We chart this below:

Chart: The Three Little PIGs

Fortunes have improved sharply for the three peripheral EuroZone countries where the situation is considered most dire at the moment: Portugal, Ireland and Greece.

Chart: Italy and Spain vs. Germany Spread
And even the largest countries closer to the core have seen their fortunes improve if we are simply to measure this with the spread of the 10-year yields.

However, if we look at the relative movement in German vs. US yield spreads, we see that yields are converging quickly . This can be interpreted two ways: US just had a couple of bad data points, so its yields are underperforming. OR, we can say that German yields are going higher because some of the fear is spreading to the very core of the EuroZone. After all, Germany can never entirely decouple from the continent and economies that surround it - and which its banks are very large creditors.

Chart: EURUSD vs. German/US 10-year rate spread

What could help us prove that this might be the case? We created a basket of a few US banks CDS prices (Bank of America, Citigroup, Morgan Stanley) and compared those prices with a basket of bank CDS in Europe (including Dexia, BNP Paribas, Credit Agricole, Banco Esprito Santo, IKB Deutsche Industriebank,  Commerzbank) to show us the relative stress levels on default risk among large banks. This gave us the following chart:

Chart: CDS price spreads on European vs. US banks.

Note that we do not have today's closing prices for the CDS', though we doubt they have improved any considering the moves in risk markets elsewhere today. To us, the chart above is rather worrisome for the EuroZone and we wonder if the market is a bit too enamored of tracking EURUSD as a simple function of 2-year rate spreads. We would be happy to see a day, in fact, when currencies entirely stop following yield spreads so slavishly – a relationship that it would make sense to see fade away in an environment of sovereign default worries (sovereign risk should mean higher yields, which should mean weaker currencies, not stronger ones – one way to track this is via CDS prices, though these also have troublesome aspects.)

Chart: EURUSD and 2-year yield spread

In any case, the EURUSD is back higher apparently on the unemployment surprise that seemed to get the market exciting about bidding up the shorter term US treasuries again, which sent US yields lower.

Looking ahead
Tomorrow we have one very key event for the EuroZone sovereign debt situation: the Irish parliament is set to vote on the new budget. This is an interesting test of how many politicians are willing to commit political suicide ahead of the next round of elections – which will apparently come almost immediately if the budget is not passed, but could also be on the way sooner rather than later if . The new budget is so austere and such a shock to the system in Ireland that it is hard to imagine anyone signing off on it, but the politicians apparently fear chaos rather than pretending – pretending that modest growth of the Irish economy will be possible in the coming few years as the government chops the minimum wage, raises taxes by 9% of GDP and cuts deeply into public outlays, all while paying close to 5.8% on a rescue package agreed on with the EU/IMF.

Good luck, Ireland – it’s admirable to try the austerity route, but this plan looks like deflation-in-a-can as long as Ireland is linked to the Euro and virtually guarantees that the Irish economy shrinks faster than it can raise tax revenues to pay for its past debt sins. Neither is it fair to Irish tax payers, who must now foot the bill for bad decisions made by bondholders who were also participants in the country’s housing bubble. How are they going to feel pain? This will not stand – everything . While the budget is expected to squeak through now, a rejection would cause some measure of chaos in the short term as it raises the odds of an Irish default now (low odds) rather than later (definite odds, uncertain timing).

Another interesting event tomorrow is the planned run on European banks – a run urged on by Eric Cantona, the former French footballer, with unknown level of participation. This is clearly only a symbolic threat to Europe’s creaking banking system, but interesting nonetheless as a measure of popular outrage on the situation across Europe.

Be careful out there.