I wanted to expand on the issue going on in Europe with respect to funding. I’ve been contending the situation is getting worse, not better. And as a result, we’re seeing a blow-off coming in the Euro, which in spite of the recent “strength” we’ve seen, has some very fundamental issues and it’s questionable it will continue to exist in its current form.
But first, I wanted to present a more comprehensive view of the term structure of Dollar/Euro Libor spreads:
The telling thing here is the fact that the short end has risen much higher than the long end, so this is a bear flattening in action.
I should probably explain why I look at the spread between Dollar and Euro Libor rates in this manner. Here’s why (emphasis, mine):
In response to the reemergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the reestablishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.
via FRB: Press Release–FOMC statement: Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank announce reestablishment of temporary U.S. dollar liquidity swap facilities–May 9, 2010.
That was all about this:
The purple circle goes back to the start of the sovereign debt crisis. What nobody was talking about then was the sell-off in the Euro being driven by funding concerns with banks. I wrote a post back in May where I came to the realization that these events are all about banks trying to fund themselves in the most relevant currency they can use. To try and illustrate that, let’s take a look at the direction of those Libor spreads and the EURUSD exchange rate.
First, let’s take a look at a longer term daily EURUSD chart:
So you can see there was a bounce in early June and the Euro has been riding it ever since. To get better visibility into what happened, here’s another EURUSD chart over a shorter timeframe:
Note the sharp break in the uptrend and change in trajectory of the rally. But I want to focus on the beginning of the uptrend, June 8. You can see what was happening to the spread between dollar and euro Libor:
Right around that time frame, spreads started widening. So as funding was getting scarce,
Meanwhile, here is a look at Euribor curves going back to the beginning of the year:
One of these days I’m going to get something up and running and treat these properly by plotting them out as 3D surfaces to look at. But that day is not today. Regardless, you can see the curve is having some dramatic shifts out. Again, developing a 3D surface of Euribor, euro Libor and dollar Libor would probably help us in thinking this through to understand what’s going on.
But in the meantime, here’s are a couple of graphs of Euribor/Euro Libor spreads:
The humped nature of the spread curve indicates to me there are issues in the front-end of the curve out to 3mths and then they relax.
I’m curious as to why it happened, but I’m almost certain someone smarter than me is already working on it…