I was wondering when I would go back to talking about contagion risk and systemic risk in the Eurozone. I haven't done it for a long time. Also because here in AdviseOnly (as those who usually follow us know), we've been cold on the Eurozone for a while.
The return of the spread
And now here I am, with BTP yields climbing, the spread over the Bund as well, and ancient Balrogs crawling out of the caves of time. Everywhere we return to neurotically speaking of the fragility of the Eurozone, of the two-speed euro, of Greece and Italy, of systemic risks. As well as imaginative and improbable plans for leaving the euro by populist political alignments, from here and beyond the Alpine arc. In fact, it is no coincidence that these jumps in spreads occur after Le Pen's announcement that she wants to leave the euro and start printing money.
After similar statements, it is clear that the financial markets are getting to work, repricing political risk in the Eurozone: in short, as the elections approach in France, Germany, Holland (and perhaps Italy), they are measures.
To understand if and how much to worry, it is worth analyzing the spreads in detail. In particular, those of ten-year government bonds of Italy, France, Spain and Portugal compared to the Bund, ie the German ten-year bond. We do this by numerically measuring the strength of the virus, of the latent and invisible factor that moves these spreads, attributable to systemic and contagion risk in the euro area. Indeed, if there were a "breakup" of the euro, several countries could experience similar problems in repaying their debt, and the markets are already starting to price in this eventuality. After all, the problems of one element of the financial system, for example a nation or a bank, tend to spread quickly and with an adverse impact on other elements of the system, all of which are closely connected to each other (primarily the banks). The overall effect can quickly become catastrophic.
I then extracted from the history of daily spreads over the last 15 years (source Bloomberg) the systemic risk shared by the countries most vulnerable to the fate of the euro, separating it from the background noise, using a statistical methodology, the analysis of principal components (or PCA – if you have any technical questions, write in the comments, I will be happy to answer them).
Well, the systemic risk associated with sovereign debt in the Eurozone looks like this (technically it is the “first principal component” of the PCA).
The graph shows that the virus is regaining strength: the upward trend is quite clear (and the analysis of the main components shows that France is leading the rise). After all, systemic risk has never disappeared from the Eurozone, its ideal habitat: a frail structure, a monetary union, but not a fiscal and political one, far from that ideal of an "optimum currency area" often referred to by economists. A Eurozone with asphyxiated economic growth, unstable banks and suffocating bureaucracy, unable to manage migratory flows and which, in short, has never solved its biggest problems. A clay giant.
This is the glass half empty.
But things have changed…
The glass is half full, however, is that we are a long way from the dramatic levels of the 2011-2012 bubo. In fact, some progress has been made since then: the banking system is a little more solid from a capital point of view, the economy is not doing well but is undoubtedly doing better and, most important of all, Mario Draghi continues to buy bonds like crazy (although he hopes not to do it for much longer).
Furthermore, there is not only the government bond market. Thanks to our Eurozone Risk Barometer, which uses a broad spectrum of indicators, looking not only at the government bond market, but also at currencies, the interbank market, the real estate market, stock exchanges and derivatives, we have relatively comforting. Why yes, the Barometer is below the critical threshold of 50, thus signaling "low pressure" on the markets - that is, systemic risk greater than normal - but certainly not a dramatic situation. Just take a look at the values in 2007 and 2008 to realize this.
In short, the Eurozone is today the largest concentration of systemic risks on the planet (and in fact we are "light" on asset classes linked to the Old Continent), but there is certainly no need to panic - the important thing is to monitor the risks and be ready to act.
However, I feel that in the coming months we need to talk more about spreads.
Source: AdviseOnly
