Goldman: SOVEREIGN RISK IS SPREADING LIKE WILDFIRE
Nov. 21, 2011
From Goldman’s Francesco Garzarelli, it doesn’t get starker than this…
Sovereign Risk Spreading Like a Wildfire
Pressures on Euro area sovereign bond markets have progressively intensified and spread like a wildfire. Sparking the flames has been in the introduction in early June of ‘substantial’ private sector involvement in the restructuring of Greek debt, crystallizing the notion of default risk in sovereign securities. Pro-cyclical policies, including the introduction of provisional capital buffers related to government bond holdings by banks and higher initial margin requirements on repo at private clearing houses, have all but fanned the flames. Meanwhile, ‘firewalls’ to mitigate contagion across the financially integrated EMU countries are still under construction, as ECB President Draghi has lamented at the end of last week.
The damage to asset prices and investors’ confidence since the start of the third quarter has been substantial. The 2-yr yield differential among the three main Euro area countries – Germany, France and Italy, which account for two thirds of its combined GDP – is now as wide as in the early 1990s, i.e., before the introduction of the Euro (France-Germany: 130bp; Italy-Germany: 583bp). This is important because, in pre-EMU days, sovereign risk had its main outlet in the currency market. Indeed, controlling for the FX risk through forwards rates, yield differential across sovereigns were actually by comparison quite small relative to current gyrations.