The resilience of the euro has got the market talking

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It’s fair to say the resilience of the euro amid escalating concerns over a possible Greek debt default is perplexing the market at present, at least based off the sentiment received in our email inboxes this morning.

Despite other asset classes, both physical and derivatives, showing signs of renewed stress, the euro seems nonchalant for the moment.

Ray Attrill, global co-head of FX strategy, fixed income, currencies and commodities at the NAB, picks up this theme this morning.

Here’s a snippet from Attrill’s always-entertaining morning note:

“Given the news that greeted the incoming Asia-Pacific market on Monday morning – that talks between Greece and her creditors in Brussels on Sunday had collapsed after just 45 minutes – we are probably not alone in thinking that the single European currency would have been lower than Friday night’s close when we walked in this morning. Not so. EUR/USD sits slightly up on the day (+0.13%), albeit eclipsed by the AUD (+0.45% to 0.7765) and GBP (+0.26%).

Whether complacency/belief that an 11th (or 13th?) hour political deal will be struck on Greece (isn’t it always?) or that Greek default and potential Grexit will be a good thing for the rest of the Eurozone, is hard to say. What we can say is that other markets are not behaving with quite the same nonchalance; European equities had another bad day (Eurostoxx 50 -1.85%), US Treasury yields are lower vs. Friday night’s close, Bund yields are slightly lower and peripheral Eurozone bond yields have blown out (Greece by 37bps at 10 years, other Eurozone peripheral bonds by between 14 and 21bps). And EUR FX volatility, which very often gets driven by spot market moves, not vice versa, has risen to its highest levels since mid-Jan, at 3-months now 50% higher than its Feb. lows.”

That sentiment is also picked up by Richard Franulovich, chief currency strategist at Westpac, who ponders the question whether the euro is underpricing Greek tail risks again.

“If you thought EUR was underpricing Greek tail risks you would have a point.

The slide below shows the level of an array of Eurozone financial instruments, measured as a six month z-score. We normalize the data to facilitate a more objective comparison across financial instruments.

As of today’s European markets close the 3mth EUR FRA/OIS spread, the European senior financials ITRAXX CDS index and the Spanish-bund 2yr sovereign bond spread are all trading at least two-standard deviations from their six month trends. EUR/USD 1mth implied vol is not far behind.

At the other extreme EUR is trading close to +0.1 z-scores from its 6 month trend. The Eurozone stoxx index, the EUR one-year basis swap and one-month 25 delta EUR/USD risk reversals look similarly ‘complacent’ in terms of their pricing.”

And here’s the chart he refers to:

Franulovich looks at other periods of heightened stress in European sovereign bonds over the past five years which, unsurprisingly, have all centred around Greece.

“It begs the question when EUR might start to more forcefully reflect tail risks that are increasingly being discounted in other markets. There’s no hard and fast rule looking back through history. In Q2/Q3 2010, Q4 2011 and Q1/Q2 2012 – three periods of extreme stress – EUR similarly defied growing sovereign stresses but eventually relented. In Q2/Q3 2010 EUR eventually started depreciating more consistently in response to sovereign stress roughly four months later, in Q4 2011 the lag was a shorter one month while in Q1/Q2 2012 the lag was two months.”

So, based on a historic perspective, while the euro tends to lag moves in other markets during periods of heightened market stress, it has a tendency to eventually “catch up” to the moves seen elsewhere.

Will that be the case again, or will the euro remain resilient despite heightened default risks? That’s the question everyone is asking at present.

Time will tell, again.

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