By Simon Derrick, Chief Currency Strategist, BNY Mellon
- Italian/German sovereign yield gaps still at unexceptional levels historically
- Growing downward pressure on German/US sovereign spreads
- Market unlikely prepared for EUR weakness
As expected, political developments within Italy have seen investors starting to focus on the EUR once again. With this in mind it’s worth considering a few simple facts:
Sovereign Yield Gaps
Although there has been some widening out in the yield differentials between Italian and German sovereign debt over the course of this month, two-year and five-year spreads are only just getting back to their average levels for the past two decades.
With the Five Star Movement and the League making it clear in statements yesterday that they wish to return to a “pre-Maastricht setting” in European economic policy (before the introduction of the EUR and common fiscal rules) it would seem that, in the absence of an "ECB put”, there is space for these differentials to widen out further.
To understand how far they can travel, it’s worth recalling that during the height of the eurozone crisis in 2011, the key Italian/German sovereign yield spreads blew back out to where they stood in the early to mid-1990s (when the ITL had lost almost a third of its external value). While there is no suggestion at present that this could happen again, this still provides a useful benchmark of how far Italian spreads can move in extremis.
As noted on Monday that there is also little evidence to suggest that since July 2015 markets have moved to price EUR exit risk into sovereign markets.
Given that an argument could now be made that the EUR should be considered more akin to an exchange rate system rather than a single currency, this is surprising.
Widening intra-European spreads are, in turn, bringing downward pressure to bear on key German/US sovereign spreads. The net result of this is that two-year, five-year and 10-year German/US spreads have moved out to some of the weakest levels (in terms of European currency support) in 30 years.
On the face of it, the EUR doesn’t appear to be particularly extremely valued against the USD. It currently stands within a hair’s breadth of its January 1999 opening price against the USD and less than 3% below its average price since then.
However, it should also be noted that the latest CFTC data shows that non-commercial net positioning in EUR contracts on the CME still remains at the kind of levels last seen when the EUR was trading close to USD 1.45 back in 2011 (see chart below).
This sense of a market that is not particularly well prepared for a EUR decline is supported by the benign valuations still evident the pricing of six-month and 12-month implied volatility, as well as the fact that 25 delta risk-reversals for the same periods remain close to the most neutral levels during lifetime of the currency.
Given this, it is also worth noting that the EUR has experienced five distinct episodes over the past 20 years when it has fallen at a pace of 15% y/y or more.