Europe creaks

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Overnight, Italy paid 6.504% to borrow for six months: up 353.5bps from the prior Auction (and up ~406bps from the average of the prior six Auctions). Their 2yr yield rose 34bps to 7.66%; 5yr +21bps to 7.74%; 10yr +15bps to 7.26%. Inverted curves for Sovereigns when policy rates are low (as they are now) suggest distress. It means that the marginal buyer is thinking about ‘recovery’ (if you discount all paper by a the same amount, the short yield will rise by more).

The worrying thing about this is that the short tenders are the ‘easy’ ones to get away. Italy aims to raise EUR8.8bn next week (28 and 29 Nov) via auctions of longer paper, and on present performance 10yr ~8% seems plausible.

Adding to the sense of crisis, S&P downgraded Belgium to AA, citing protracted political uncertainty, and a slowing economy (something that could be said of pretty much every Sovereign).

As a result of all this, the market has pulled even further back from European banks. The 3m EUR/USD cross currency basis swap fell to -156.25bps, which is the lowest it has been since Q4 2008. This means that European banks are willing to lend EUR cash at 3m EURIBOR less 156.25bps, in exchange for 3m USD at LIBOR flat.

With three month Euribor at 1.475%, that means that we have -ve rates on EUR cash if you are willing to lend them USD cash. That is, European banks must PAY someone to take their EUR off them for 3m, and then also PAY 3m USD LIBOR on the USDs they borrow.

I think it’s fair to say that we are now in a full blown financial crisis.


    1. Honestly, I think an orderly breakup is the best option. The various economies need lower exchange rates to balance out. Even with the cost of a breakup a lower exchange rate is likely be more socially tolerable than the years of pain an internal devaluation would require.

      1. A breakup would be catastrophic and in no-one interest. A breakup would bring a world recession that would eclipse the GFC — easily. The solution is to start the printing presses and print Euro. With the printed money recapitalize banks so they can buy EU bonds and at the same time reduce public debt and increase fiscal integration. Basically what the FED did during the GFC. The ECB should be given full monetary powers, what France is asking and Germany is refusing. Monetary policy needs to be set for the whole of EU not for Germany and the Netherlands only.

        1. I agree it would be very costly, but the EZ’s problems stem from imbalances, and those imbalances won’t go away if the ECB does QE. The periphery must lower unit labour costs the hard way – by having lower inflation than the core. That may mean persistent 30% unemployment for a decade or so in Spain. That is not sustainable, and it is also potentially quite costly.

          This was the structural problem which led Freidman to predict it would break up following the first large recession way back in 1999.

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          1. The problem is too much public debt, with no growth and low inflation which makes the public debt hard to repay. So printing to create inflation and deflate the debt is the solution. That should devalue the Euro which is still about 20% too high vs US dollar and the Chinese currency. The overvalued EURO is really the root cause of lack of competitiveness at the EU periphery.

          2. I can only partly agree. The problem is not only debt that cannot be paid back – in Italy it is mostly public, in Spain and Ireland it was (initially) mostly private, and in Greece it was both – but economies that require external funding.

            They are locked into the EUR and so cannot adjust their net exports to balance diminished capital inflows, so they have to operate on the (S-I) and (G-T) side.

            Of course, a lower EUR would help them deal with that adjustment as it would boost everyone’s NX – so i agree with you there. But there remains the underlying problem of relative competitiveness, and so it is not the full solution.

            Fixing this is not quite so simple as some suggest. ECB QE and Eurobonds would buy time, but the underlying issue is relative unit labour costs.

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          3. If you think about it, the same competitive “peripheral” issues could be present in Australia and the US among the single states. So the markets seems to be punishing an “incomplete” EU union, where single state interests are still prevailing.

            On a larger scale, it does seem to me that large credit expansion (private or public) has allowed the EU and the US to “hide” the great rise of the Chinese economy, at least temporarily.

            But two credit crisis have now underscored that this imbalance is not sustainable. Let’s not forget Italy is one of the biggest manufacturing economies in the world and one of the hardest hit by the Chinese “cheap labour”. In EURO terms, the periphery has become uncompetitive, Italy is still among the 10th major exporters in the world. I think taking the EURO down to US $1.10 , where it was 10 years ago, would solve a LOT of issues in the periphery! Sometimes it’s that simple! I do not understand this German obsession with an overvalued Euro.

  1. I think what is happening is a self fulfilling negative bond bubble.

    I agree I can’t see how the Euro can survive when markets are as silly as this also agree on the social consequences.

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