Analysis: Markets far from expecting euro zone break-up

By Jeremy Gaunt, European Investment Correspondent

LONDON (BestGrowthStock) – Listening to some — primarily Anglo-Saxon — commentators, one gets the impression that the euro zone risks collapsing under the weight of debt in its weaker economies.

Analysts are discussing the idea that economic differences between countries may be too wide for the zone to survive, and that it may have to break itself up.

Markets themselves, however, are telling a different story. Individual financial instruments, such as sovereign bonds and bank debt in the weakest countries, have been hit hard by default fears. But movements in most markets show most investors do not think the euro zone faces the dangerous and expensive prospect of a break-up.

Indeed, correlations between markets suggest investors are not nearly as afraid of a systemic crisis in the zone as they were back in May and June, when the panic over Greece’s debt problems was as its height.

Consider the euro itself. Although yields on Portuguese and Spanish 10-year debt are at record highs near 7 percent and 5 percent, and Ireland is negotiating an international bailout, the currency has not reacted strongly.

The 30-day correlation between the euro/dollar exchange rate and the spread of the 10-year Greek government bond yield over German Bunds — the risk premium which investors demand to hold Greek bonds — was minus 0.65 in June but is currently minus 0.19.

Minus 0.65 is a fairly strong negative correlation — heading toward the limit of minus 1.0 — and shows investors sold the euro heavily in June because of fears of a Greek debt default. By contrast, there is now very little correlation between the euro and expectations for Greek debt.

For Ireland, the correlation has moved from minus 0.61 to minus 0.29.

Also, the euro remains strong historically. At around $1.32 and despite a roughly 7 percent fall over the past three weeks, it is still close to 13 percent stronger that it was at the depth of the Greek crisis. It is far above its lifetime average of $1.188, and above its average for the past 200 days, which is a key level for currency traders and is now at $1.3131.

Nor does market positioning imply fears of a currency zone break-up. The latest Commodity Futures Trading Commission figures actually show a small net long position in the euro.

These are figures for the week to November 16, and the next set of data, normally released on Fridays, may show a shift. But the reaction in the currency options market to the Irish crisis has been tame.

According to IFR, implied volatility levels for the euro are still well below those seen in May and June. Implied one-month vol hit a high of 18.75 percent in late May and 12-month vol reached a peak of 15.1 percent. The equivalent figures now are near 14 percent, a level that suggests some concern but not a huge amount.

In the meantime, there has been demand for euro “puts” — options which provide the right to sell the euro at a given price. This suggests expectations for further euro weakness. But the 1.65 percent premium currently demanded over “calls,” the right to buy, is much cheaper than the 3.0 percent seen in June.

CORPORATE STRENGTH

It is a similar story on European stock markets, where most companies are being buoyed by signs of surprisingly robust German growth and general improvement in the euro zone, as well as healthy corporate cash balances.

The EuroStoxx index, a broad gauge of euro zone equities, is about 9 percent higher than it was in early June despite falls in the past few weeks.

Correlations between the index and bond spreads also show that while they are not insignificant, the euro zone bond crises are not overwhelming equities. The 30-day correlation with changes in bond spreads is now minus 0.38 for Greece and minus 0.36 for Ireland. In May, the Greek correlation was minus 0.86.

While the prices of bonds issued by Irish and some other banks have tumbled, the euro zone corporate debt market remains fairly healthy. The iTraxx Europe index for investment grade euro zone debt is at 111 basis points compared with 141 bps in June; a lower number implies more risk appetite. The iTraxx Crossover index of more risky corporate “junk” bonds is at 494 bps, down from 633 bps in June.

There are at least two major reasons for the easing of markets’ fears about the euro zone as a whole since June. One is that the European Union has set up a formal mechanism to handle debt crises, the 440 billion euro European Financial Stability Facility (EFSF), and the Irish bailout now underway shows the EU is willing and able to use it.

Secondly, expectations for debt defaults in a few euro zone states have grown in recent weeks as Germany has pushed a proposal to create a mechanism for orderly sovereign debt restructuring. But debt restructurings could actually reduce the risk of a systemic euro zone crisis, by helping countries return to health without a need for them to leave the zone in search of currency depreciation and lower interest rates.

THREE YEARS

The markets see the time of maximum risk for debt defaults as roughly three years from now, after the three-year terms of Greece’s bailout and the EFSF expire, at which point the EFSF will be replaced by a crisis mechanism that may be less protective of bond investors.

The curves for prices of credit default swaps, used to insure debt against the possibility of sovereign default, rise to peak at about two years for Greece and three years for Portugal and Ireland; Ireland’s curve later resumes rising to hit a fresh high five years out.

But euro forwards, which are contracts to buy euros at future times, do not suggest investors see a major rise in risk for the single currency three years from now.

The euro has dropped steeply in the forwards market this month but the move in three-year forwards has been similar to that for shorter tenors, when taking into account interest rate expectations.

(Additional reporting and graphics by Scott Barber; additional reporting by Neal Armstrong; Editing by Andrew Torchia)

Analysis: Markets far from expecting euro zone break-up