WITH the spread between Irish and German bond yields even wider than it was during May, speculation is rife that the Eurozone crisis is about to re-emerge with a vengeance. A run of terrible data has not helped matters: on Friday, Irish GDP was revealed to have shrunk 1.2 per cent in the second quarter of 2010 and European industrial orders figures disappointed.
If the crisis does flare up again, how should traders get exposure? Spread-betters could short the Eurostoxx 50 – or the euro. But because forex markets are all relative, a weak euro depends on Europe’s major trading partners faring better than Europe, which is by no means guaranteed. Another less commonly considered method is to bet on Euribor, the European interbank offered rate, which is the average rate at which the major Eurozone banks lend to one another.
Brokers offer spreads on Euribor priced out of 100. This is because short-term bank loans are priced by subtracting the interest rate from 100: instead of lending £100 and receiving capital plus interest back, one lends £100 minus the interest rate and receives £100 back.
Euribor has been on the rise in recent months, reaching 0.88 per cent for three-month loans and 1.42 per cent for 12-month loans last week. This compares to 0.71 per cent and 1.27 per cent in June.
Looking at the chart (right), traders will notice that the rate only went up gradually as the Eurozone crisis flared up in May. This reflects that although the markets were concerned about the possibility of sovereign defaults, this took time to feed through into an increase in the rate at which banks lent to one another, in part thanks to ongoing liquidity programmes by the European Central Bank (ECB).
But it also speaks to the way Euribor is calculated. The rate quoted is based on the average rate at which a panel of 57 major European banks lend to one another – but it is only calculated after the top and bottom 15 per cent have been discounted. So even if smaller or less capitalised banks were struggling, the mainstream banks were able to redirect lending to one another and, with interest rates low, keep Euribor from rising steeply.
But now, analysts at RBS are anticipating slowing growth to trigger what they call a “death debt spiral”: that is, states having to pay higher spreads on gilts as their growth slows. The rise in Euribor reflects that banks have been building up their balance sheets in order to weather such a storm – and in order to prepare for the end of the ECB’s special liquidity programmes in January. Moreover, RBS analysts write: “We continue to keep a close eye on the usage of the (ECB’s) lending facility, which can signal the potential for banks with funding trouble.” A steadily rising Euribor could prompt more banks to turn to the ECB for help, in turn deflating the interbank rate as excess liquidity enters the system.
Another factor to watch is the change in capital ratio requirements under Basel III. Although this was not as stringent as expected, the real change in the requirements will not actually be known until November, when it becomes clear which assets the new rules will affect. So traders betting on the interbank rate should keep a sharp eye on the changing framework of financial rules in Europe.
The steady rise of Euribor signals that the coming Eurozone crisis is a new progression from the turmoil seen in May, in which banks are saving despite low interest rates. And if banks are beginning to put the brakes on lending to one another, it means that beyond sovereign debt concerns, consumers and financial institutions are going to feel the pinch.