Concern over a new European systemic crisis has increased sharply in recent days as wider swap spreads and higher short-term funding costs indicated rising pressure on interbank markets.
European Central Bank chief Mario Draghi’s 2012 pledge to do “whatever it takes” to prevent a eurozone meltdown faced a serious test as investors dumped financial sector equities and piled into default protection, pushing Deutsche Bank’s credit default swap premium to the highest level in over four years, while key barometers of financial market distress flashed red.
“The fact that the recent sell-off is not driven by the tail anymore, and it is more widespread, points to one conclusion: that the tide has turned. Risks are not only idiosyncratic anymore; systemic risk is rising,” said Ioannis Angelakis, credit derivatives strategist at Bank of America Merrill Lynch.
During the financial crisis the spread between forward rate agreements (interbank lending) and overnight index swaps (tied to central bank rates) was a much-watched gauge of bank credit quality. In recent days the FRA/OIS spread jumped from 12bp to as much as 16.5bp.
Ten-year interest rate swap spreads rose to 41bp on Thursday, compared with 31bp in mid-January. Wider swaps spreads are a sign of declining liquidity in interbank markets.
“From Italian non-performing loans to the prospect of lower interest rates for longer and disappointing bank earnings, there have been a few factors that have focused investor attention on the European financial sector,” said Marcos Arana, a strategist at Deutsche Bank. “The worry now is that banks could restrict lending to the real economy, which would have a knock-on effect on the eurozone recovery.”
January’s ECB bank lending survey suggested improving loan growth in the fourth quarter, alongside easing credit conditions and stronger bank capital positions. The problem for ECB policymakers ahead of their March 10 monetary policy meeting is that the snapshot may already be obsolete.
“There is a question of whether the survey was too backward-looking and does not reflect the new market stresses on credit channels,” Arana said.
In the worst case scenario, interbank stress could reignite the negative feedback loop in which pressure on the financial sector leads to higher government borrowing costs, increasing bank funding costs further, Arana said. That could catapult the European economy back to the dark days of the sovereign crisis.
While investors have been dumping bonds and equities over the past several weeks, swaps spreads only showed signs of strain in the past few days. With that in mind, the coming period will be a crucial gauge of the potential for a full-blown crisis, analysts said.
“Relative to the equity and credit moves since the beginning of the year, swap spreads have shown a relatively low beta,” said Fabio Bassi, head of European interest rate derivatives strategy at JP Morgan in London. “Now that is beginning to change, but it’s worth noting that these are very early signs of stress and not on the same scale as we saw during the financial crisis.”
The ECB continues to provide unlimited liquidity to the financial system through its programme of targeted longer-term refinancing operations. Some 21% of banks participated in December’s TLTRO funding round, compared with 49% in June.
“We can’t be complacent, but we are in a better position than before because of the actions of the ECB,” said Bassi. “It remains to be seen whether the signs of recent credit stress develop into something more serious.”
