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On rising euro volatility amp yields

Article By: ,  Financial Analyst
April 10, 2012 4:59 PM

As market emphasis shifts to US earnings, here are a few stats on the latest deterioration in the old continent;

- Spanish 10-yr yields +20% since LTRO-2 was announced on February 29.
- Italian 10-yr yields +8% since LTRO-2, and 19% since PSI deal on March 9.
- Greek 10-year yields +22% since PSI deal.
- Portuguese 10-yr yields are down 15% since Mar 9 PSI, but up 10% since Mar 28 low.
- Deposits at the ECB reach €785 billion, just below their Mar 5 high of € 827 billion

Spanish government bonds are now the latest victim of bond traders’ typical one-country assault amid speculation that Spain will be the fourth recipient of a eurozone bailout. At a time of deepening recession, Spanish authorities have selected “education and health” sectors for € 10 billion in budget cuts. Cuts in these sectors have yet to prove successful or sustainable the he eurozone. Little surprise that the biggest yield gainers are of nations, which are not yet bailed out—Spain and Italy.

The chart below shows how option-based volatilities, whether VIX (on S&P 500) or one-month volatility on EUR/USD, have deepened their decline (a positive dynamic) in the period between LTRO-1 (Dec 20) and LTRO-2 (Feb 29). Also during that period, market sentiment was also boosted by liquidity creating-purchases from the Bank of England, Bank of Japan as well as further easing from the BRICs. Consequently, EUR/USD’s stabilization was attained as euro option one-month volatility tumbled to its lowest since January 2008. But this is now changing. Today, Fed hawks are increasingly silencing the dove’s insistence to see more data improvement, while the ECB has not uttered the LTRO in over a month.

The combination of protracted gains in Spanish government bond yields and rebounding volatilities (EUR one-month & VIX) would be needed to break the euro’s floor of $1.2900. The possible fundamental culprits for such occurrence:

- IMF demanding further budget cuts from Spain’s planned €10 bn. cuts.
- New hawkish dissent at April FOMC meeting (released at FOMC statement & later at May minutes.)
- Negative surprises in US earnings (earnings, revenues & guidance.)

And with Q1 earnings season emerging on the back of a 12% rise in the US currency (USD index) accumulating over the last seven-months, the prospects for a negative translation effect on US multinationals (over 20% of S&P500), may add more scrutiny to the “eurozone uncertainty” factor.

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