I have listened to many talk about the rising funding costs for Europe over the course of 2011 as the market focuses on the rally in yields in Spain and Italy. I want to point out something that I find interesting; notably that for the European Core, as measured by a basket weighted by outstanding public debt, the current cost of funding is actually below the 10-year average. This is because German funding costs have dropped quite dramatically.
Indeed, as the chart below shows, in July 2008, yields in both Germany and Spain hovered around 4.68%. Current yields in Spain are around 5.37% and in Germany they are around 1.93%. While Spanish yields have risen by 69 basis points, German yields have dropped by a whopping 275 basis points. Certainly the spread between the two has exploded, from around 0 to 343 basis points, but the majority of that move is not explained by the sell-off in Spanish debt. Rather it comes through the "flight to quality" buying of German debt.
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As for Italy, as the chart below shows, in July 2008, yields in Germany were around 4.68%, and in Italy around 5.13%. Current yields in Italy are around 7.00% and in Germany they are around 1.93%. While Italian yields have risen by 187 basis points, German yields have dropped by 274 basis points. While the spread has risen from 45 basis points to 507 basis points, again the majority of the move is not explained by the sell-off in Italian debt, but rather from the buying of German debt.
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Core Public Debt:
Of public debt within a basket of the core Europe countries of Germany, France, Italy and Spain, 33.7% belongs to Germany, 30% to Italy, 26% to France and 10% to Spain. Based on current 10-year yields, the basket average is around 4.07%. As the chart below shows, the funding cost for the core is still below the 10-year average, and indeed still below the yield seen pre-Lehman's demise in 2008. While conditions may be poor in Spain and Italy, that has not yet been transferred to Germany and France. Indeed, Germany is enjoying 10-year yields that are lower than those enjoyed in the U.S.
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As European fiscal restructuring begins following Treaty changes in March, I believe we will see a tightening of core European spreads to Germany. Once again this may actually come from the movements in German yields rather than the dropping of Spanish and Italian yields. Investor discomfort with Spain and Italy is likely for some time. The risk, however, is that the "flight to quality" in Germany is likely to be somewhat unwound, pushing German yields higher and so collapsing the spread. Certainly I expect Italian and Spanish yields will drop, however I expect German yields will rise to a greater extent.
Following Lehman's demise I estimated that the USD was overvalued by about 13% on the "flight to quality" move into the USD. Today I estimate the USD is about 9% overvalued relative to the euro, this time on European uncertainty. I believe that as European muddling turns to actual treaty change, resulting in fiscal austerity and fiscal union, the unwind of this flight to quality will act as a wind against the market's expectation for a lower EUR/USD. In addition, I would argue that while European policy has been slow due to the complexity and legality of treaties, once those treaty changes have been passed, confidence will return within the eurozone. This confidence will act as a wind against the negative growth to be expected from austerity measures. While European spending and confidence has shut down on tape-bomb uncertainty, it should return as the policy mist lifts.
In the meantime, as the market waits complacently short the EUR/USD at the most extreme levels according to IMM data, for a French downgrade; it remains oblivious to the risk that the IMF will announce a European 'Trust' fund, separate from the IMF General Fund. This is leaving the EUR/USD open to significant short-squeeze risk should such a fund be announced. Last night Canada said they would contribute to a Europe Fund within the IMF should other G20 countries also commit. G20 Contributions to a separate European Fund "Trust" continue to be an upside risk that is heavily discounted by the market.
The LTRO auction has been labeled as a failure because sovereign yields have risen over the past few days. However that is because the market believed that banks would engage in a carry trade, borrowing from the ECB to buy sovereigns. This again is misguided. The funds borrowed by local banks will have a number of uses. For one it means that local banks will not have to sell more peripheral debt in order to raise capital, thus stemming some of the recent incessant selling. Secondly it means that banks will not have to go to the market to raise funds ... this is the carry trade. Banks would have budgeted 4%-plus for their borrowing needs if they were to go to the market, and now they are only paying 1% to the ECB. This back-door funding will help recapitalize European banks. Their funding needs are taken care of at least until Europe can regain its economic footing.
There are many known negatives to the eurozone, be they funding or growth concerns. However there are also considerable headwinds to the downward scenario, and given market positioning combined with possible IMF surprises I remain of the belief that EUR/USD downside is limited, while the upside is entirely unprotected.