Macro Wrap – Don’t Forget About Europe

by Enis May 24, 2013 7:44 am • Commentary

After dominating headlines for 3 years, Europe has taken a back seat in 2013, with little news from the European periphery we all used to hear so much about.  But Europe is still 1/3 of global GDP, and remains the key to continued risk appetite.

All of that newfound knowledge we all acquired reading about the GIIPS (I’ll change the acronym back to PIIGS when the Italian and Spanish 10 year yields are back above 5%) will still come in handy.  The issues in the periphery have simmered, but have not been solved.  Southern Europe is still mired in depression, with little change in policy so far this year.  Crucially, in the land of unintended consequences, the BoJ, not the ECB, has been the major supporter of the GIIPS.  The BoJ’s policy has forced Japanese savings abroad, with a good chunk of that ending up in European peripheral bonds, where yields were above 5% at the start of the year.

That support has allowed the ECB to watch from the sidelines, and bought some time for the European banking system.  Unfortunately, that time has not been well spent, as European growth remains dismal, and European banks are still woefully undercapitalized (with Deutsche Bank’s recent capital raise one bright spot in a sea of silence).

For European calm to continue, the BoJ and the Japanese government likely need to remain steadfast on current policy.  If the Japanese waver on their aggressive policy when they see JGB yields move higher (particularly since Japanese banks have likely been complaining to the BoJ about the recent move in yields, given their massive interest rate risk), then European peripheral yields are likely to move higher again when flows from Japan reverse.  Peripheral yields are higher the past 2 days, and I anticipate those yields moving closely with the yen.  Higher yen, higher yields.  Lower yen, lower yields.

In that sense, the effects of Japanese policy and JGB / yen movements will be felt across global financial markets.  It’s been one reason we haven’t had to worry about European summits for the past year.  Aside from peripheral bond yields, I’m watching the price action of the European banks for a gauge of how concerned the market is about renewed European systemic risk.  The 1 year chart of the SX7E, the European banking index:


1 year daily chart of SX7E, Courtesy of Bloomberg
1 year daily chart of SX7E, Courtesy of Bloomberg

The 110 level has been a pivot point for the past 9 months, alternating as resistance and support, and coincides with the 200 day moving average.  That’s the spot to watch in the near term.

European calm continues for now, and only a natural correction has taken place so far, in both the bond and stock markets.  My radar is on high alert though.  While the world watches Japan, the longstanding lurking threat continues to be in Europe.