Europe On The Verge Of Another Full Blown Credit Crisis

Sovereign spreads widening to record levels Friday amid fears of defaults in the euro zone‘s periphery. As the weekend approaches, mixed messages from European leaders leaving the markets wondering what to believe. The credit market is now beginning to look a lot like it did in the first week of May, when Greek 5-year spreads were trading around 1.000 basis points as investors priced in the possibility that it would be the first country in the euro zone to fail to meet its debts, and the threat of contagion to its peripheral peers was very real.

“On the eve of the weekend the feeling of déjà vu in the credit markets is almost palpable.”

Gavan Nolan


But this time it isn’t Greece causing the turmoil. It’s all about Ireland, once lauded as the richest country in Europe, but now suffering the indignity of having its solvency questioned in the markets. Irish CDS spreads hit a record of 630 bp’s on Thursday morning and were subject to violent turbulence as a maelstrom of rumors hit the country which in turn projected on to the financial markets. As markets close Friday afternoon, investors are  in a state of unusual uncertainty.

The turbulence in the credit markets is fast approaching the record levels only seen in May earlier this year.

The volatility – and the rumors – continued to haunt the markets on Friday.

Spreads opened tighter due to a combination of short covering and a soothing statement from EU finance ministers. The announcement, made by Britain, Germany, France, Italy and Spain, clarified that any potential burden-sharing by bondholders would not take place before 2013, when the European Financial Stability Facility (EFSF) expires.

“Crucially, they also stated that bondholders’ participation would be voluntary and would not affect existing holders of debt,” credit analyst Gavan Nolan at Markit Credit Research writes the weekly update “Credit Wrap”.

Unsurprisingly, spreads rallied after the announcement.

However, the real impetus for the spread tightening came once again from the rumour mill:

Sevrel reports buzzed through the markets hinting that an EU bailout for Ireland was imminent. This was quickly denied by the Irish finance ministry.

Spreads came of their tights after the denial but held on to most of their gains. But that wasn’t the end of it.

New reports emerged in the afternoon suggested that a bailout was indeed being planned in the next few days. And again, the Irish government was forced into a rapid rebuttal, stating that it had not requested aid from its EU partners.

“Nonetheless, Ireland’s spreads finished the day at 540bp, some 55bp tighter. The volatility throughout the day was indicative of dealers’ unwillingness to hold on to large positions going into the weekend – memories of May haven’t faded yet,” Nolan comments.

Other peripheral sovereigns, and Portugal in particular, were moving in tandem with Ireland.

The Markit iTraxx SovX Western Europe index was 8.5bp tighter at 168bp, its largest one day gain for some time. But it is still over 30bp wider than levels this time last month, and its underperformance versus the Markit iTraxx SovX CEEMEA – an emerging markets index – is marked over recent months.

“Both indices trade with a large skew, and if this is taken into account the convergence between the two indices is even closer,” the credit analyst points out.

This reflects the stronger fundamentals of eastern European sovereigns compared to the profligate and fragile EU members on the Mediterranean and Atlantic, he explains

“Today the western European index recovered some ground. Whether this trend can be maintained will depend on the EU’s decisions over the coming days,” Gavan Nolan concludes.

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