Divyang Shah, Senior IFR Strategist
The eurozone crisis is (was?) as much about sovereign risk (high government debt) as it was about banking sector risk (insufficient capital). We have seen how with the Cyprus bailout there has been movement toward divorcing sovereign and financial risk.
Cyprus was a template in the sense that everyone except for insured depositors have the potential to be bailed in (including senior bondholder and uninsured depositor) as the eurozone looks to limit the costs of dealing with its banking sector.
What happens if there are insufficient funds available to make good on the deposit insurance or recapitalisation if bail-in measures prove inadequate remains to be seen. Early in the life of the EFSF it too had insufficient firepower with policy makers hoping that limited resources will suffice.
With the ECB’s Asset Quality Review for the main banks – which is said to be conducted by independent experts – we might not have a long wait to find out if there are sufficient funds. Eurogroup president Dijsselbloem has told us that that “The outcome… we don’t know yet, but it might be worrying”.
When we had the discussions over EFSF/ESM firepower there were rating implications for the semi-core countries with particular attention to France. There is the potential for such concerns to resurface and we are tempted to start legging into a short France vs Germany trade especially as the 10-year spread has narrowed all the way back to 45bp.
The problem with making a negative bet on semi-core or peripherals is clearly:
1) the wall of money argument as excess CB liquidity creates strong demand for yield and a movement across the risk spectrum, as well as…
2) the cost of carry especially as timing a turnaround in sentiment is difficult.
