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Wednesday, November 23, 2011

European stress levels reaching a boiling point

Funding stress levels in the European zone are slowly inching towards an unsustainable situation as different credit markets across the continent are showing signs of faltering. The big news overnight is that Germany held a Bunde auction which could only be described as a disaster. With yields touching 2% on their 10 year note, returns were not enough to entice investors as the German Bundesbank had to purchase 39% of the offering so that the auction would not fail. While this is not the same situation as the peripheral countries, in the sense that they do not have to pay loan shark rates on their debt, it is a sign that investors would rather hoard their cash rather than being in any sort of debt security.
We are all aware the off the stress going on in the sovereign debt market but the other devil quietly lurking in the shadows is the interbank funding market. Banks primarily fund their activities through the use of the overnight market where they either borrow money if they are short or park money if they are over funded. The failure of this market is what ultimately brought down Lehman in 2008 as they were not able to fund their day to day operations. The London Interbank Overnight Rate (LIBOR) is the main rate and it has been slowly creeping since the beginning of summer. The European banks that are in better shape have significantly pulled back their operations in the overnight market while the struggling ones are in increasing need of it. This is creating a negative feedback loop where rates are continually rising and liquidity is continually falling. It is these secondary credit markets that can provide the early warning signs of a banking crisis.
The Euro has taken a beating overnight as seemingly continuous barrage of damaging news will not let the currency catch a breather. The common currency is down 3.4% on the month and 6% from its high of 1.4247 on Oct 27th. The downward trend channel is holding strong and the failure of the US debt committee couldn’t even help the Euro out. It will be up to the politicians to figure out a way to calm the market but their track record so far is not reassuring.