Europe’s Tower of Terror

By Global Macro Monitor

The circus continues in Europe. No big bazooka EFSF coming out of G20 to put a firewall around Greece and save Italy. Greece is a sideshow and the Italy-Germany bond spread is what you need to watch as an indicator of the short-term direction of the risk markets. Clearly, at least to us, risk wants to run into year-end but fear of the EU macro bear is palpable and reflected in the elevated VIX even on big up days.

Maybe the U.S. markets can decouple, but the fear and linkage in the financials is just too strong, in our opinion. Here’s the scoop from AFP,

Germany-Italy bond yield spread widens to record

The difference between the German and Italian sovereign 10-year bond yields widened on Friday to a record of 4.57 percentage points.

The difference in the cost of borrowing for the two countries widened because money flowed into safe-haven German bonds, pushing down the fixed interest on those bonds, while concern about the state of Italy’s public finances sent Italian rates up.

The yield on 10-year Italian debt also rose to a record high point, putting Italy close to levels at which financing its debt mountain is widely considered to be unsustainable.

So what is the trade? If Italy continues to blow out and a big bazooka EFSF bailout fund is not attainable, the EU will be faced with certain death or massive ECB bond purchases. We think they will choose the later, which makes the Euro a sell against the dollar and gold a buy, in our opinion.

At that point, maybe the S&P500 and Euro will become less correlated. Time to rewrite the algo? And time to rewrite “risk on/risk off”? Jusk askin’.

Italy Germany Bond Spread

  1. David Lazarus says

    The linkage via the financials is so strong that a banking collapse in Europe will wipe out the US money centre banks. In fact I am surprised that the interbank markets are not already starting to avoid the big US and European banks because of the risks. It is only a matter of time before there is another credit crunch.

  2. Douglas says

    But for the most part the Euro (because of valuation) trades inversely to the dollar. And gold trades inversely to the dollar. So the Euro goes down and the dollar up. But what about gold? If it follows its past performance (generally), it too should go down as the dollar rises.

    Confession. I am long the dollar and gold but I do worry about this.

    1. David Lazarus says

      Gold has a special place as a store of wealth during panics, and inflation fears. The best way to look at gold is if thing get really nasty. I can understand that sentiment right now. Though for most people such concerns are meaningless as they do not have enough wealth to diversify into gold.

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