Is Europe Doomed?
Europe is continuing to see deterioration across the board. Whether we are looking at banks, corporations, or bank’s ability to be able to access the wholesale dollar funding market. With the European Central Bank (ECB) saying that they will start raising rates we are seeing things start to break. Will Europe be able to raise rates? The answer is clearly no, and I will explain below.
One of the first things I have noticed in the last couple of days, and it is truly astonishing is what is happening with rates volatility. Below (Chart 1) you can see 1M/2Y EUR ATM swaption implied volatility, and this is against the USD and JPY within that chart also. Euro rates volatility has now surpassed USD rates volatility, and this is something that is extremely rare from a historic standpoint. This would also be the first time ECB has hiked since 2011. Therefore I assume vol. is pricing the distribution of outcomes to be wider.
We have seen that there is obviously a lack of supply of dollars and high dollar demand, but cross-currency basis swaps can also measure risk. As the BIS says, “…short-term FX swaps is much more sensitive to risk premia and bank funding strains, particularly during crisis episodes.” Even though these are a little bit longer in Chart 2, as was pointed out by E. Lefeuvre that as bank stocks have fallen there has been a widening in the basis swap. This could also as the BIS has pointed out be an issue of the inability of European banks during times of crisis to access dollar funding, and when they do obviously the premium (wider basis) would be charged to incorporate increased or heighted risk.
I updated since the last time E. Lefeuvre published it, is the ratio between the FED’s and the ECB’s balance sheet. What you can see is that as the Federal Reserve grows it balance sheet faster than the European Central Bank this leads to a narrow basis, and as the balance sheet of the European Central Bank grows faster than the FED it leads to a wider basis. This is shown in Chart 3, and with the Federal Reserves current projection between the dot plot and expecting balance sheet run off this basis I am forecasting will widen even further from here.
Now we are starting to see deterioration in the credit default swaps within Europe, as seen in Chart 4. The European banks are starting to see probability of default rise. Higher rates could put further pressure on European banks, and current policy will also put additional pressure on assets and currency vol. which will cause deterioration in some of the assets held within the CDS index. Especially on the currency volatility side as pointed out above. I expect CDS index to continue to rise, and think we will see loan impairment charges (LICs) to increase rapidly. This will happen as asset quality deteriorates, and this will put further upward pressure on the CDS index.
Finally, in Chart 5 we have started to see deterioration within the corporate sector within Europe. European credit markets are starting to price in probabilities of default that we have not seen since the years following the European sovereign debt crisis. We have now seen the spread on BofA European high yield index widen rapidly and have seen many days where credit spreads are moving more rapidly than CDS index. However, CDS index will always be more reactionary than bonds, as this just happens because of the way they are structured. Further rate hikes will cause more deterioration, as corporate credit quality deteriorates and puts more pressure on companies within Europe. These spreads should continue to rise and watching the rate of change will be something to keep an eye on. If they widen to much, and probabilities of default continue their upward march, and I expect this to happen this will play a part in ECB inability to raise rates.
With all the ability for the ECB to raise rates seems highly unlikely. The situation within Europe is already deteriorating. You have financial stress, credit market stress, dollar shortage stress, and currency volatility surpassing that of USD. Outside of the ECB we also have the issue with the war, and that is another factor that puts stress on Europe. Between the mix of macroeconomic and geopolitical issues the ECB I believe is just talking, and has almost zero ability to do anything. This is nothing more than warm air being blown by the ECB to try to ease fears about inflation within the EU. However, I don’t think anyone buys what the ECB is selling.