Decoupling, Interrupted

Remember back in long distant memories (from a month ago) when all the chatter was for the US to decouple from Europe as the former (US) macro data was positive and a 'muddle-through' consensus relative to the European debacle took hold. Since 12/14, European markets have significantly outperformed US markets (both broadly speaking and even more massively in financials - which is impressive given the strength in US financials). Furthermore, we saw a decoupling of correlation (de-correlating) between EUR and risk as a weaker EUR was positive for risk as USD strength showed that the world was not coming to an end (and Europe was 'contained'). Well things are changing - dramatically. EUR and risk were anti-correlated for the first two weeks of the year and since then have re-correlated. The last few days have seen EUR weakness (Greek PSI and Portugal fears) coincident with risk weakness (ES and AUD lower for instance as US macro data disappoints and a dreary Fed outlook with no imminent QE). Given the high expectations of LTRO's savior status, European financials have been the big winners (+20% from 12/14 and +15% YTD in USD terms) compared to a meager +12% and +8.8% YTD for US financials - with most of the outperformance looking like an overshoot from angst at the start of the year in Europe (which disappeared 1/9). With EUR and risk re-correlating (and derisking very recently), perhaps it is time to reposition the decoupling trade (short EU financials vs long US financials) though derisking seems more advisable overall with such binary risk-drivers as Greek PSI failure, Portuguese restructuring (yields have crashed higher), and the Feb LTRO pending (which perhaps explains the steepness of vol curves everywhere).


EUR and risk have re-correlated in the last two weeks.

Heading into the new year, EUR and risk were once again re-correlated and then as the decoupling myth of a US economic miracle took off, we saw USD strength (EUR weakness) as a positive risk signal and EUR and risk de-correlated (red dotted square). This anti-correlation has reversed in the last week or so and with very recent EUR weakness (and JPY strength) risk has re-coupled and is now drifting lower post Bernanke.

European financials have taken off in the last two weeks relative to everything.

The same pattern can be seen in the behavior of risk assets themselves (rebased to USD returns) - the chart above shows percentage performance from the mid-December lows (and dotted YTD performance). From mid December to the start of the new year, US and Europe were highly correlated. For the first two weeks of the year, European markets (green - financials, and black - broad stocks) underperformed (and de-correlated) from US markets (pink - financials, and orange  - broad stocks). Since mid January they have re-correlated and Europe has leaped ahead as reflexivity has taken hold in a mutually reinforcing LTRO-has-saved-the-day and we've had no bad news cycle.

The most-watched European sovereign spreads have compressed in the last two weeks - all except Portugal!!

But quietly behind the scenes as everyone focuses on Italian 2Y yields dropping fast and German financials tearing higher (and for some reason people are surprised that auctions are going off well when everyone knows the ECB is there for banks to flip-that-bond to?), Portuguese bond yields (and spreads above) have crashed higher.

With the biggest fear not the impact of an isolated Greek default (given its pure size is relatively small) but the precedent it sets for other stressed European nations (and the Euro-zone itself), perhaps the canary is more like an Albatross-in-the-coalmine that is being ignored for now as momentum and short squeezes hide the harsh reality that LTRO solved nothing but a short-term liquidity problem leaving capital short and balance sheets in peril still for European (and US) banks broadly.

Charts: Bloomberg


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