The credit default swap markets are signaling caution as CDS spreads on eurozone sovereign bonds are widening. It includes “powerhouse” Germany (AAA) as well, according to this Markit report. It tells you where money is going (U.S.) and signals where the market places its trust. Consider that France’s Trésor spread is double that of Germany’s. Of course France is rated one notch below Germany. The TIC (Treasury International Capital) report from the Treasury (next Friday) will tell us which countries are sending us the most cash. What will this do to Treasury yields?
Sovereign risk has been central to the direction of risky assets over the last few years. The ability – or inability - of governments to intervene in dysfunctional financial markets is one of the main factors to assess when investing. And that was more than apparent over the month of May. Eurozone sovereign spreads widened sharply as the debt crisis threatened to turn into a disaster. The concurrent banking crisis and the negative feedback loop with sovereigns could accelerate the process. Can the rest of the world remain immune? The CDS market suggests otherwise. Spreads in emerging markets and the US have widened significantly in recent weeks, and their fortunes will probably stay linked to Europe as the crisis unfolds. …
The obvious place to start is in Europe. A glance at the eurozone rankings table below demonstrates that the currency bloc is in trouble. All of the names that trade in the CDS market have seen their cost of protection rise and six of them – Cyprus, Portugal, Ireland, Spain, Italy and Germany – have all widened by 20% or more.
The first five names in that list are predictable but the last sovereign is perhaps surprising. Germany is a safe haven in times of strife and its debt generally benefits from a flight to quality. Indeed, bund yields are at record lows due to capital inflows. But the CDS market doesn’t replicate the bond market in such distressed times and often diverges. Hence a large positive CDS bond basis has opened up – the largest in the eurozone. The UK, another country that benefits from safe haven status – due to its monetary independence – has a similarly large positive CDS bond basis, according to Markit data.
But the CDS market may also be reflecting real, fundamental concerns about Germany. It is becoming increasingly clear that the “powerhouse” of Europe is not immune to the turmoil engulfing its fellow eurozone members in the periphery. The Markit Germany Manufacturing PMI for May came in at 45.2, indicating the sharpest deterioration in operating conditions for nearly three years. Germany is an export-led economy and the waning demand from elsewhere in Europe is being felt.
Then there is the broader issue of the future of the eurozone. It would be no exaggeration to state that Germany has the fate of the single currency – and maybe the EU – in its hands. The second round of Greek elections is due on June 17 and the result could have a seismic impact across the continent. If the hard-left Syriza emerges as the largest party it increases the probability of Greece leaving the eurozone, with all that systemic risk that implies. Even if the centre-right, pro-bailout New Democracy comes out on top it is unlikely to calm matters for long. It is hard to see the conditions of the current bailout being met and there will be demand from the new government for breathing space and eventually more money.
Germany has taken a hard line on the bailout conditions but it is just about feasible to see it relax its stance. But the real problem is elsewhere in the periphery. Spain’s CDS reached a record 600bps as the month drew to a close amid heightened fears about its banking sector. Spanish banks are undercapitalised and the sovereign can’t provide the funds without inflicting severe damage to its credit standing. It could request assistance from the EFSF but is wary of the stringent conditions that would come attached. Calls for capital to be directly injected into the banks from the EFSF have fallen on deaf ears and in any case contravene the terms of the fund.
So it has become clear to most market participants that the time for piecemeal solutions has come to an end. If the eurozone is to stay intact then as well as monetary union there will have to be some form of fiscal – and therefore – political union. A first step would be a banking union, i.e. eurozone-wide deposit guarantees, a common regulator and a dedicated fund for bank recapitalisation. Further down the line eurobonds
would be the next logical step. Without debt mutualisation it is difficult to envisage how the periphery would be given the time to become
competitive while staying in the eurozone.
But this logic has been fiercely resisted by Germany, who refuses to countenance mutualising eurozone debt. Their borrowing costs would almost certainly rise – they can’t go any lower – and eurobonds would be very hard to sell to a hostile German public. In fact, fiscal and political union would probably be quite unpopular in most eurozone countries. But without a quasi-federalisation, or at least the firm intention to go down this route, the risk of a messy break-up increases. This helps explain the widening in Germany and across the core and periphery.
One additional point: Estonia,
… Estonia has entered the Top 10. The Baltic country is seen as a poster child of austerity, and its low tax, liberalised economy is admired by right-leaning economists. However, the effects of its policies took a terrible toll on the economy, and its output remains well below prerecession levels.
Ignore the second sentence. Estonia’s austerity is not causing its problems; rather, it was the boom.