One of the most interesting stories to emerge out of what has been a pretty wild January for global markets is the rapid rise in European rates.
That rise has Morgan Stanley rates strategist Laurence Mutkin worried about a resurgence of the European sovereign debt crisis that everyone says is over, and according to Mutkin, ECB President Mario Draghi faces a critical moment in the coming weeks.
As sentiment has ramped up around the globe and investors have staged massive inflows into equity funds and other risky assets, "safe-haven" plays like German bonds and short-term debt have sold off.
Draghi helped spur this rise in rates, along with that in the euro, when he announced at the central bank's most recent policy meeting that the decision against lowering benchmark interest rates was unanimous among the ECB Board of Governors.
On top of everything, European banks are now beginning to repay loans extended to them by the ECB during the depths of the euro crisis. This has provided further impetus for the upward trajectory in EONIA rates as banks return to interbank lending markets to fund themselves.
In his latest note to clients, titled "Now We're Getting Worried," Mutkin explains why he is so concerned about these developments.
Although the ECB has provided a "backstop" in sovereign debt markets with the threat of bond market intervention via its yet-untested OMT program, Mutkin says now is the time to start thinking euro crisis again.
Mutkin writes (emphasis added):
Higher funding rates are simply not good news for highly leveraged borrowers: and euro area sovereigns’ debt levels are all high (indeed, higher than in 2011 and 2012).
If the rise in core yields this year were driven by evidence or expectations of stronger nominal growth, one could argue that this would offset (or more than offset) the effect of higher yields. But that’s not the case.
The rise in EONIA forwards, and so in Bund yields and swap rates, has been driven by the technicalities of the erosion of excess liquidity in the banking system. This may be a symptom of banks’ improving health, but it still means funding costs are rising, while the outlook for nominal GDP isn’t.
So our conclusion is this: although there are certainly differences in each year’s specific circumstances, it may be that the rise in core rates was a significant driver of the turnaround in systemic sovereign risk in 1H11 and 1H12.
Therefore, there’s reason to start worrying now, especially as the pricing of systemic sovereign risk is back at 1H12 lows, according to our PCA-derived measure.
The charts above show how this year is looking a lot like the last two years so far in terms of patterns in the European interest rate markets.
So, will 2013 prove to be different from 2011 and 2012? Mutkin says it's just too early to call.
However, Draghi once again holds the keys to the kingdom, so to speak. Mutkin writes:
In the near term, therefore, much depends on how ECB president Draghi responds to the recent rise in EONIA forwards at next week’s Press Conference.
Our economists doubt he’ll lean heavily against the rise in rates, but we hope he'll avoid the mistake his predecessor made in blithely characterizing the rise in EONIAs after the 1y LTROs’ expiry in 2010 as being no more than evidence of the improving health of the banks.
The ECB will hold a press conference next Thursday at 8:30 AM ET, following the announcement of its interest rate decision at 7:45. We will be listening closely to see how Draghi responds.
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