Distress in the Eurozone is normally reflected in financial markets by rising spreads between peripheral (read: Italian) and core (read: German) assets. The so-called ‘BTP spread’ measures the cost of borrowing money in Italy versus in Germany and is one of the key barometers of European financial stress and risk. In fact this spread is so important that it defined the first quarter of Lagarde’s ECB Presidency. However, Spain’s difficulty in getting the pandemic under control is upsetting its cost of borrowing and providing a new candidate to measure risk.
The spread between Italian and Spanish yields has shrunk to a 2 year low of just great than 50 basis points. The deterioration in credit worthiness of additional Eurozone states will continue to put pressure on the Euro system and will create a headwind in the Euro and create a force to weaken it. The gap between the core and the periphery is a big problem for the Euro and Germany’s financial claims over the rest of the Eurozone have continued to rise to an all time high in September to in excess of €1tn. With the European Recovery Fund’s implementation in question, risk is on the rise in Europe. EURUSD will therefore be vulnerable to a sharp correction lower in the short run if risk conditions deteriorate further.
In another ultimately relatively directionless but tumultuous trading day, the value of the Pound yesterday was once again determined by Brexit related headlines. Initial reports of renewed tension between Ireland and the United Kingdom over fishing rights pushed the Pound lower. A subsequent Bloomberg report claiming the potential for a deal to be reached following intensified talks between Frost and Barnier reversed earlier losses. The Pound held firm as the UK reiterated its demand for agreement on a post-transition trade deal ahead of the European Summit next week (15th October) and confirmed the government would walk out of negotiations if an agreement was not struck. The Pound was also stable despite Scotland introducing additional measures to restrict public liberties to combat the coronavirus spread.
Short-dated implied volatility has been on the rise as talks look to be reaching their endgame amidst renewed acts of political brinkmanship. Reports that talks at present would, if conclusive, create an Australia-style EU trade arrangement could upset any potential Sterling gains upon realisation of a trade deal. Australia does not have a trade deal with the EU but an agreement to limit the barriers to trade where possible. If the UK were to offer concessions to the EU to achieve such a framework this would risk being interpreted as a bad deal by the market and limit any Sterling gains.
Discussion and Analysis by Charles Porter