This is a question we’ve thought about before: Seeing as bond spreads are blowing back to crisis highs, why aren’t we seeing the same of panic euro selling we saw earlier this summer?
Morgan Stanley has some thoughts, though no concrete answers:
As shown in Exhibit 1, a relationship emerged between the performance of EUR/USD and European sovereign risk – proxied here by the Spanish 5Y CDS spread – in early 2010. In June the EUR bottomed and the spread peaked as the European governments agreed to provide multi-lateral support to sovereign credits. But after the initial positive response, concerns about long-term risks continued to overhang the market and spreads started widening out again starting in mid-July. The EUR initially tracked the spreads but over the past two weeks it appears that the link is breaking with the EUR holding firm as the spread widens back toward the June highs.
It remains moot whether this break is significant or, as was the case in January when an apparent break proved to be temporary. But we suspect it is not coincidental that the break emerged in the wake of the August 13 release of much better- than-expected German Q2 GDP growth, and we suspect that the EUR is now principally driven by expectations on global economic activity rather than the CDS spread.
Photo: Morgan Stanley
But wait, there’s more:
Further evidence that global growth rather than CDS spreads is becoming a more dominant driver of the EUR is apparent in the EUR correlation vs non-European currencies. As shown in Exhibit 2, during the six month period prior to August when sovereign concerns were dominating the EUR, correlation with other currencies plunged. Over the past month, as the EUR link to the CDS spread has faded, cross-currency correlations have rebounded – with the exception of the MXN. While the swing was more modest, the pattern also holds for the correlation between the EUR and SPX.
Photo: Morgan Stanley
The implication, of course, is that the dollar will lose its appeal as a “risk off” asset (it already has) and sell off on bad economic news, if the economy continues to weaken.