Wednesday, January 11, 2012

European liquidity conditions appear to be improving

This may be somewhat esoteric for many readers, but the discussion here focuses on key indicators of Eurozone liquidity conditions which appear to be improving. If that is indeed the case, then systemic risk is declining and the likelihood of a Eurozone-led catastrophe may be lessening. Nevertheless, it remains the case that the fundamental problem facing the Eurozone—bloated government spending against a backdrop of struggling economies—has not been addressed, so what improvement we see here is unlikely to be definitive, and only partial (i.e., access to dollars is normalizing, but default risk remains).

This chart compares 2-yr Eurozone swap spreads (a measure of systemic risk and bank counterparty risk) with the cost that Eurozone banks must pay to access dollar liquidity (the Euro Basis Swap).

According to Macrostory, the Euro Basis Swap is "a derivative product that allows the holder in the case of a Euro swap the ability to swap EUR for US dollars. In simplest terms the more negative the value the greater the demand for USD." (HT: Mike Churchill) The rise in the blue line (note that the y-axis represents negative values) in the above chart illustrates how difficult it became for Eurozone banks to acquire dollar liquidity beginning in August. As my friend Brian McCarthy explains, one reason for this is that US-based money market funds have all but eliminated their holdings of French bank commercial paper. This entailed the repatriation of dollars, which left the Eurozone market very short of dollars, and it coincides with the Euro's weakness against the dollar since last August. In a more generic sense, it reflects the increased reluctance of U.S. investors to lend to the Eurozone financial community.

Swap spreads rise when banks and large institutional investors are reluctant to take on counterparty risk, and that usually happens when there is increasing stress on an economy and/or financial markets, since that means more default risk to any lending activity. In the case of the Eurozone, swap spreads have risen in lockstep with the increased risk over the past six months or so that one or more of the PIIGS will end up defaulting, since such an event increases the likelihood of widespread Eurozone bank failures and/or a financial market meltdown.

I note that the two variables are highly correlated over this period, and I also note a slight tendency for the basis swap to lead swap spreads. I don't know if this relationship is likely to hold, but it does suggest that the pronounced decline in the basis swap in the past week or so could be foreshadowing a welcome reduction in Eurozone systemic risk. That, in turn, could be the result of the Fed's new-found willingness to open swap lines with Eurozone banks, and also the result of the ECB's recent attempt to ease financial stress by offering in late December an almost unlimited amount of long-term financing (LTRO) to Eurozone banks, with an expanded list of collateral options.

All of this would help explain the significant decline in Italian and Spanish 2-yr yields (see chart of Spanish 2-yr yields above), in the past several weeks.

In short, the ECB and the Fed have been working hard to apply what might be termed by skeptics as "band-aid" solutions to the sovereign debt crisis, and the evolution of basis swaps and swap spreads noted above is evidence that their efforts have had some traction. At the very least this provides more time for the market to sort out and adjust to the fundamental risk presented by countries like Greece and Italy that have spent and borrowed more than they can easily repay. This doesn't mean that defaults are less likely, but it does suggest that they may be more easily absorbed by the market, and thus that the consequences of a PIIGS default might not be as catastrophic as the market has been fearing. And, as I noted yesterday, that brightens the outlook for risk assets in general.


Benjamin Cole said...

Bloated government spending, but also a too-tight monetary policy: The Japan story as well.

John said...

Don't know what the percentage is in Europe, but here in the U.S., consumer spending makes up something like 70 percent of the economy.

Most consumers are also workers. To the extent they feel insecure in their jobs, demand will stagnate or fall, along with the economy in general.

Given that so much of our economic activity has consisted of buying and stuffing our houses with junk made in China, I don't see this as such a bad thing.

McKibbinUSA said...

Dark times are descending upon much of Europe -- more at:

I fear instability in Europe, especially because the ECB is oblivious to what "the people" might think and do in response to severe economic austerity...

brodero said...

Excellent...these swap rates are
largely underfollowed by extremely
important to understanding the stress
in Europe....

Donny Baseball said...

and as if on cue, Spain and Italy have pretty successful auctions that bring yields down substantially! Good call Scott.

Hey John, maybe we should elect people to ban shopping for junk from China. We'd all be better off if everyone stayed home and read Neitzsche or Shakespeare, no? Did you ever stop to think that there is clearly some utility derived by people from stuffing their homes with junk from China?? If that's what they freely choose to do, who are you to question this as a basis for commerce?

John said...


I like that libertarian stuff, really, I do. People should be free to make the choices that bring them happiness. It's just that I'd like a level playing field when it comes to imports and exports, including:

1. Similar and decent OSHA standards,
2. 40 hour week, unless folks want to work longer,
3. Similar and decent environmental regulations.
4. Wages that allow a person to some time off to enjoy life and put something away for the future. To "work to live," instead of "live to work."

We in the US spent 100 years getting reasonable protections for workers, but when the jobs were sent to China, the protections stayed behind.

By the way, I was a big fan of Nietzsche back in the sixties. Great linebacker.

Donny Baseball said...

Ha! I love it. I'm a Sam Huff man myself. Can't wait to watch their heirs battle it out on Sunday.

yeah, I'm for a level playing field as far as it goes, but i wouldn't want to see china take regulation to the absurd extreme that we have - and they likely won't, they're too smart. They know that we in the West can take a good idea and get stupid with it.