This page has been archived and commenting is disabled.
EURUSD And European Sovereign Risk In Perfect Harmony
We have extensively discussed the extremes to which European Sovereign spread risk has moved over the past few months. Furthermore, if we normalize by looking at a GDP-weighted credit spread across all of the members of the euro-zone, we are at all-time record wides on this measure. One question that has come up again and again is 'given the market's credit perceptions, why isn't the EUR lower?'. It appears that this is mainly due to regime shifts in the relationship as the correlation between EURUSD and European sovereign risk is extremely high when government intervention (specifically QE uncertainties and fed swap lines) is not rife. The point is that for the last four months, EURUSD and European sovereign risk have been almost perfectly correlated suggesting that as long as there is no ring-fence on risk, the EUR will continue to weaken significantly and at a minimum the EURUSD is an effective hedge against sovereign credit deterioration. Watching this relationship may provide insight into repatriation effects or government intervention.
Looking at the chart of the EURUSD against the GDP-weighted sovereign risk of European nations - one could be forgiven for seeing little relationship. Furthermore, based on the current level of credit risk, some might expect EURUSD to trade 20 big figures lower.
There are 3 periods where the EURUSD-EUR Sov Risk relationship is almost perfectly correlated - and we believe this is the normal environment/regime. However, post the announcement of QE2 and immediately after the cessation of QE2 the two markets diverged dramatically with a total breakdown in the correlation.
Prior to QE2 - EURUSD and EUR Sov Risk was very nicely correlated (Box 1 in chart above).
When QE2 was announced (first red oval in the chart above) in August 2010, it appears EUR rallied dramatically as perhaps the USD devaluation fears ripped into the exchange rate - this announcement had zero impact on European sovereign risk. We do wonder if the move in EURUSD was related to Fed swap lines (more on this below).
Once QE2 began in earnest we saw the previous highly correlated regime shift back (Box 2 in the upper chart) and worries over European Sovereign risk had a negative impact on EURUSD and vice versa.
This perfect correlation held until the end of QE2 which coincided with an escalation in Greek issues and the contagion spreading across the periphery (the second red oval in the upper chart). It appears the EUR remained strong during this post QE2-period - perhaps on the beginning of the repatriation fears we have discussed or more likely the unwind of the fed swap lines action we noted above.
Once we hit the summer-time and sovereign risk began to accelerate higher, so the EURUSD began to track it once again (as seen here - relating to Box 3 in the upper chart). For the last 4 months, EURUSD and the GDP-weighted European Sovereign risk have been perfectly correlated and provide a critical insight for those looking for levels and bigger picture views on where the EUR goes next.
Perhaps for insight into whether intervention is being used - as some have suspected recently - tracking this relationship will prove useful. Furthermore, some scenario analysis is possible to judge the impact of significant moves in the larger economies (which will clearly have a larger impact on the GDP-weighted measure) - for example - a 100bps rise in Italian Bond spreads alone (given the impact on the GDP-weighted credit risk) would imply approximately a 140pip drop in EURUSD.
Charts: Bloomberg
»
- 9770 reads
- Printer-friendly version
- Send to friend
- advertisements -
Zero divided by zero equals zero.
"Zero divided by zero equals zero. " WTF !
Did you study behind the school?
Unfortunately that is the new math people are learning. It's along the lines of (-infinity + infinity) = 0 Good luck with that.
*Sigh*
And people wonder why Americans are not competitive for technical jobs....
Both worthless currencies. I guess I have to spell it out for you. I can do the math, tks. Happy Holidays to you too negative nancies.
A smart man would have taken their lumps and moved on...
Interesting graph, Tyler!
My I ask what the exact formula you use for .EUSOVRSK, please?
Junked for stupidity
Actually, 0/0 is a damn good explanation of fiat currency.
Value, after outstanding debt, divided by value it imparts to the citizens of these societies = the amount of printing nessesary to sustain the equation.
Or some bullshit like that.
Obviously a product of government subsidized higher education:) Nuf said
0/0 = NaN.
the harmony can't last.
http://expose2.wordpress.com
Great stuff.
From a game theory perspective lets say Roesler-Merkel continue their opposition and the EURUSD keeps dropping, isn't there a limit to how much it can go? I mean, the $ 'strength' chokes off any recovery in the US(exports 2015, credit etc etc) no?
If you pretend fiat has value, then the fact that in the EMU they are increasing supply at a slower rate then in the USA you woul assume long term this is bullish for the EUR. Thats assuming fiat currencies retain the faith of the sheep for a few more years.
Happy Thanks Everyone!
Markets short term oversold, could go down some more Friday but be aware of a sharp rebound into next week and all the way through December 13th, the next and last FEDster meeting for this year!
If pension funds don't make them 8% all he'll brakes loose, frankly I don't expect that, Europe will, again, come up with "something", so will the FEDster's, all in all we'll have a Santa rally, that's a given!
Come January, a total different story!
You'll have a Santa rally or a Satan crash
Indio in that order, it will happen!
it's no coincidence that a war was planned at this time!
"gotta get me that oil" said ZeroDamus!
I've just followed JPM advice by some guy by the name Wax Man (selling my commodities holdings) and diversyfied into bonds of Europe, Japan and US. What's the hell is going on? In 1 day they kicked me on 2 fronts and I'm fully expect the next blow. But thanks Joe, January must be better as you say.
Lotta people banging on about a santan rally, catching falling knives, picking up pennies in front of a steam roller etc. Don't go against the trend my friend, the trend is your friend. :)
from hyper-deflation to hyper-inflation...bitchez? If we follow the John Paulson script we load up on the CDS contracts then buy the banks once they get clobbered. Of course if "the Europeans refuse to acknowledge the sanctity of said contract" as was done in Greece...
QE 3.5 bitchez.
libertarian86.blogspot.com
Another question comes up, over and over again. Who is going to pay for all of this? Shopping is fun, until you get to the check out. The world has been running on revolving debt. We are now seeing the inevitability of default. repossession of assets will become a common occurrence in 2012.
http://georgesblogforum.wordpress.com/2011/11/02/the-daily-climb-2/
Bath of America very close to a four handle, looking forward to Tyler's headline if/when it hits
Blogger spam--ZH the new hub for it.
Thats good for me. I'am all in US bonds since spring. I've made + 20%. In the long run? The dollar and US bonds are toast. But I know the right time to switch to gold/oil.
Look at The Fed's assumption of worst case scenarios for banks! The Fed assumes that 3 mo Treasuries are 0.10% through 2014, 10 yr Treasuries hover around 2% and mortgage rates rise to 5% for 2012, then fall back to 4%. THIS IS A STRESS TEST FOR CAPITAL??????????????????????????????????????????????????????????????????????????????????????????????
Upcoming Case-Shiller Report and The Fed Reserve Comprehensive Capital Analysis and Reviewhttp://confoundedinterest.wordpress.com/
What did you guys give to the deer?
http://www.liveleak.com/view?i=c5f_1322118163
I'm doing a correlation matrix on chart 1 in the morning.
now, box 2 - agree; 3 - agree.
but where do you find correlation in that big box 1? really.. eur might be crap, but the correlation ain't far from that either.