No Crisis Unless Spain Falls?

The resilience of the euro in the face of seemingly incontrovertible evidence that Portugal will need to get assistance and that very same program and approach has not been enough to stabilize the Greek and Irish situation is amazing.

It can be arguably explained by two considerations. First that come hell or high water, the ECB, which does not pre commit has all be indicated a rate hike at the April 7 meeting. Second, existing facilities and liquidity provisions are good enough provided that Spain does not come under attack.

European officials hoped to build a firewall around Greece. It did not work. Then Ireland. It did not work with either. Portugal very soon. But these are small countries in terms of GDP relative to the euro zone. Spain is bigger than all three and then Italy looms even larger on the horizon.

Investors are interested in the strength of the firewall around Spain. We have tried to operationalize that question by looking at the correlation of the Spanish and Portuguese bonds. Correlation methodology is important. When running the correlations on financial instruments, we prefer a robust test that looks at percent change or log natural. However, when looking at bond yields--already percentages, we think that conducting the correlation on percentage is misleading. We present the results of both approaches however below and prefer the former on methodological grounds, but prudence would suggest the more conservative results of the less rigorous approach.

The correlation of Spanish and Portuguese 10-year bond yields is around 0.13 currently. We are looking at a 30-day rolling correlation that will be more sensitive to near-term shifts. The correlation had reached a peak for the year in mid-March just above 0.87. The high from around the Irish aid program was 0.89. It actually turned negative in December last year and again from mid-Jan to mid-Feb. This suggests the firewall is intact despite the recent credit downgrade and concern that Spanish banks will require more capital that officials seem to acknowledge.

Conducting correlation on the percentage of Spanish and Portuguese bond yields reveals a somewhat different picture, but also indicates the correlation is well off the recent highs. The 30-day rolling correlation is near 0.55. The high from earlier this month was near 0.73 and the high for the year is almost 0.80.

These results also suggest that a firewall is intact, but a bit thinner (greater correlation) than the other study. Investors will also be thinking of what kind of events could trigger a breach of the wall. A few come to mind. Continued pressure on Greece, Ireland and Portugal. Stress tests results that show significantly higher capital needs than the market expects. Perhaps continued ECB rate hikes after the April 7 move. Investors should watch the reception at Spanish bond (not so much bill) auctions.