WSJ:Euro-Zone CDS Is a Harbinger for Euro’s Fortunes
By David Cottle
Imagine you could insure the entire euro zone as a single entity against debt default (and imagining it is as close as we will ever get in the real world if Angela Merkel has her way).
A reasonable gross domestic product-weighted “euro-zone credit-default swap” — EZCDS — for the bloc would at present come in at a spread of 2.75 percentage points, according to analysts at CitiFX. That would make the world’s largest economy as risky a bet as such powerhouses of international finance as Lithuania and Kazakhstan. To calculate its fantasy spread, Citi aggregated the five-year CDS spreads of Germany, France, Italy, Spain, the Netherlands, Belgium, Finland and Austria, leaving out the wreckage of Greece, Ireland and Portugal. Tellingly, they found that this spread correlated extremely closely (inversely) with moves in the euro/dollar pair. It has done so since mid-2011 but, this year, the link is incredibly close.
“The close 2012 correlation with EZCDS reinforces the view that it is not the European Central Bank’s balance-sheet expansion but, rather, euro-zone policy makers’ tolerance of deteriorating sovereign credit that has led to euro weakness,” the bank wrote.
Sure enough, the euro rallied in the aftermath of the ECB’s two long-term repurchase operations, late last year and early this year. Back then, investors saw a chance that friendly ECB bank funding, and friendly bank funding of sovereigns, could ease the sovereign-debt crisis. The EZCDS dropped smartly from peaks of 2.80 percentage points in January, down to 2 percentage points, matched by a run-up in the euro. The ECB balance-sheet expansion didn’t seem to have any negative effect on the euro’s value when the CDS was narrowing. However, when the impact of the LTRO waned, guess what? The euro fell as the CDS spread widened.
This is a pretty high correlation, with a far stronger link to the euro’s fortunes than, say, other member states’ debt spread with Germany or Germany’s own debt spread with the U.S. So, if you watch nothing else for your euro steer, watch this.
Moreover, Citi reckons, a spread blowout of another 2 percentage points would see the euro trading between $1.05 and $1.10 (it’s at $1.2580 Friday morning). Alright, so this would put the CDS where Lebanon is now, but it would still be substantially narrower than where Spain and Italy currently trade alone.
