Easing of euro zone debt spreads, convergence of correlations

Posted on 06. Jan, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

A slow convergence process of euro zone sovereign interest rates has started since the ECB considered the launch of the OMT program. The OMT is not a quantitative easing program, it’s a promise from the ECB to intervene as lender of last resort should a country ask for the help of the European Stability Mechanism (ESM).

As shown in figure 1, the involvement of the ECB to “do whatever it takes to save the euro” and the launch of the OMT program in August 2012 has enabled a progressive convergence of interest rates across the main euro zone countries. The 10 years Government rates spreads between Spain and Italy on one side and Germany on the other sides reached more than 6% in 2012 and converged to below 2% as of 3rd January 2014. It seems that Draghi’s poker bluff has worked and that the convergence process may gather pace within euro zone countries as anticipated by Riskelia in April 2013 and November 2013.

The OMT is pure bluff since the mechanism has not yet been approved by the Federal Constitutional Court of Karlsruhe. As Draghi told, “the ECB has no plan B, it can only wait“. Besides, suppose for example that Italy requires assistance from the ESM; then it would lose sovereignty which would undermine the coalition of Enrico Letta and probably provoke early elections where anti status quo parties like the M5S would defeat a pro euro stance coalition. Therefore, the implementation of OMT would in fact be impossible because it would entail a loss of sovereignty from countries requiring assistance.

The convergence involves a change of the correlation structure between euro zone sovereign debts and equities. As showed in figure 3, all euro zone debts correlations with Eurostoxx 50 are converging towards zero. The situation which prevailed until 2013 involved one safe debt, the German one, one neutral debt, the French one, and two risky debts, the ones from Spain and Italy (figure 2). In the topsy-turvy world of euro zone, we had to wait until growth improved in Southern euro euro zone countries to witness an ease of absurdly high real interest rates in Italy (3.5%) and Spain (4%).

Figure 1: 10 years government spreads between France, Italy and Spain vs. Germany

Figure 2: 1 year rolling correlation between German, French, Italian and Spanish debts on one side and Euro Stoxx 50 on the other side

Figure 3: 3 months rolling correlation between German, French, Italian and Spanish debts on one side and Euro Stoxx 50 on the other side

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