FYI | Nov 18 2011
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
Things have got a lot worse for Europe in the last week, not only are Italian bond yields back above 7% but this morning’s Spanish debt auction was poorly received. Not only did the auction fail to attract the estimated amount of interest, but investors charged an interest rate of 6.97% to hold debt with an 11 year maturity. This is close to the 7% threshold deemed to be unsustainable for a country like Spain to avoid financial assistance.
So not only does Spain look like it has (finally) been dragged into the fray, but today’s French debt auction – although less dramatic than Spain’s – still saw Parisian borrowing costs rise for 5 –year debt and the spread between German and French debt widen to a fresh record. This isn’t the only sign of stress in the markets, the spread between European inter-bank lending costs US inter-bank lending costs remains at its highest level since March 2009. Although this spread is much lower than the peak reached at the end of 2008, it has jumped by 30 basis points since November as European financial institutions see their funding costs rise relative to their US counterparts.
This comes after last night’s announcement from credit rating agency Fitch that US banks are at risk from the Eurozone crisis if the problems continue to spread to the core. However, European financial institutions remain at risk from their massive exposures to debt across the region and as Italy and Spain have been dragged into the crisis this has aggravated an already bad problem.
Europe’s debt crisis has the potential to affect all asset classes. As I have mentioned before the bond market is dominating all asset classes right now and the stresses in Spain are starting to weigh on the euro, although it is likely to be a straight line lower. The impact on the euro is obvious, however Spain’s debt crisis could have some other unintended consequences.
Right now 10-year yields are surging above 6.75%, a fresh euro-era high. The more this yield moves higher the greater the chance that the bond clearing house LCH Clearnet will raise margin requirements. When this happened to Italy earlier this month it caused a huge ripple effect in asset markets: stocks tanked, the euro collapsed and German, UK and US bonds received massive safe haven inflows. If margin requirements are increased then this could cause a rush out of gold and other commodities as investors scramble to either cover rising margins or liquidate their positions. So expect a lot of volatility in the markets for as long as Spain remains under pressure.
The EU’s high command is not doing anything to calm market nerves. The EU Commission along with France are pushing for the ECB to become the lender of last resort, while Germany remains steadfastly against it. Over the last three days numerous German officials have spoken about the dangers of the ECB taking on this role, earlier today the German Economic Minister Roseler said that joint Eurobonds are wrong and reinforced Germany’s opposition to the EFSF getting a banking licence. This comes even though the Fed’s Rosengren yesterday said that the Fed could, theoretically, step in and join the ECB in a bond-buying operation to try and ease stress in Europe’s debt markets. However, while the rest of the world seems to converge around the ECB as the most realistic solution to this crisis Germany hasn’t come up with an alternative apart from more austerity and implementing the decisions agreed on October 26th that are now deemed inadequate to stem contagion from the crisis. But it seems unlikely that Germany will save into pressure to expand the ECB’s role any time soon, so yet again the Eurozone seems to be a rudderless ship on stormy seas.
This doesn’t make life easier for risky assets and European stocks markets are suffering from some heavy losses. Interestingly there was some good news out of the UK as retail sales rose more than expected in October, pushing the annual growth rate to 0.9%, up from 0.4% in September. Is this Christmas shopping come early? A reaction to QE from the Bank of England? I wouldn’t get too excited as consumption is still weak in the UK and could fade out later in the year as fiscal austerity combined with low levels of consumer confidence keep people off the high street once again.
The pound made a stab at 1.58 today, but has since fallen back towards the top of its short-term range at 1.5750. Talk of the pound becoming a safe haven is premature in our opinion. The UK is still exposed to the European debt crisis though banking and trade links, added to that the Bank of England made it quite clear that more QE Is on the table, which may limit sterling gains in the short to medium term. Thus we think that the pound could remain in a range for some time yet.
Europe is still dominating things and we seem no closer to stemming contagion from the periphery to the core, which is likely to keep things volatile for some time. As mentioned Spain’s margin requirements could be the next obstacle in the road for traders to watch out for. Also watch out for Sweden, its borrowing costs have surged today possibly due to its heavy exposure to mortgages in the Eastern Europe Baltic states. However, Swedish borrowing costs are still very low and this problem is very much at the back of investors’ minds.
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