European Liquidity Conditions Appear To Be Improving

Includes: ERO, FXE, IGOV
by: Calafia Beach Pundit

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.