Friday, January 20, 2012

Meaningful improvement in Eurozone fundamentals

Here's a quick recap of important indicators of financial market health, which all register substantial improvement, especially in the Eurozone. Even though a Greek default is a virtual certainty (Greek 2-yr yields today are 180%), these indicators suggest that the risk of contagion to other countries has dropped significantly, and the Eurozone financial system is not destined to collapse any time soon. 

2-yr swap spreads are an excellent indicator of financial market liquidity and systemic risk. Spreads are down meaningfully in the Eurozone, albeit still quite elevated. U.S. spreads are now back to a level that is consistent with "normal" conditions.

Euro basis swaps reflect the difficulty that Eurozone banks are having in obtaining dollar liquidity. Funding pressures have eased significantly in the past month, leading the way to reduced swap spreads, also a measure of counterparty risk. Eurozone financial markets are exiting the danger zone when liquidity dries up and trading freezes.

2-yr yields on sovereign debt are a good measure of the market's estimation of default probabilities. Greek yields have soared, but all other countries have seen meaningful declines in the past few months. Italian 2-yr yields have fallen by half since their peak in late November. This is rather impressive.

The cost of obtaining insurance against Eurozone defaults has not declined as much as 2-yr yields, but the CDS contracts represented here cover a 5-yr period. The combination of only marginal improvement in CDS plus significant improvement in 2-yr yields means that while the market realizes that defaults are not likely in the near term, they remain a risk over a longer time horizon. Efforts to restore liquidity and confidence to Eurozone markets have been reasonably successful, but investors have yet to see any meaningful steps on the part of the PIIGS governments to address their fundamental problem, which is bloated, deficit-financed government spending.

The decline in systemic risk in the Eurozone is one reason that the U.S. equity market has been able to move higher in recent weeks, and the implied volatility of equity options has dropped to a 5 1/2 month low. As risk declines, risky asset prices rise.


Donny Baseball said...

I find it noteworthy that Ireland has gone from a dire case to more or less out of the woods, and yet they steadfastly clung to their pro-growth tax regime in the face of withering attacks by Euro elites. Instead they attacked spending and pared back elements of their relatively recently constructed Euro-style welfare state.

Ireland's play book is the roadmap back for the rest of the Euro zone. If only Italy et al could see this clearly.

Scott Grannis said...

Exactly. Spoken like a true supply-sider!

Benjamin said...

Looks like the worst is over...the Dow is up today, seems like we are in rally mode. I expect a secular bull market, if ever the central banks let it happen.

The last three CPI readings are down or flat. We are way, way below even the Fed's niggardly target inflation rate (niggardly in light of unemployment and lost output, and real estate values).

John said...

Bravo DB: Ireland's doing a lot of things right. All citizens are entitled to health care under the public health care system. Ireland manages to stay pretty healthy spending 8.2 percent of GDP on health care vs. 17% in the U.S., which is probably the biggest economic problem the US faces.

If only American entry level workers had a minimum wage as high as Ireland's: E8.65/hour = $11.16/hr US, with some exceptions.