Where There is So Much Smoke, Perhaps There is a Fire

There are two spotlights in Europe today. France and Switzerland and their problems are intertwined. Despite denials by various French officials, the market suspects there is sufficient smoke to indicate a fire. Reuters reports that an Asian bank has cut credit lines to top French banks and other counter-parties are considering the same.

The French banks are perceived to be too big to fail--not that there is real talk at this juncture along those lines. However, the share and bond prices are eating away at their Tier One capital and the market situation is getting worse, not better. If push comes to shove, France can recapitalize its banks. However, to do so would likely be at a cost of its triple A rating, even though all three leading agencies have a stable outlook on France's sovereign rating.

Separately, we have been concerned that if, in order to meet their own fiscal objectives, Italy and Spain were to beg out of the Greek 2.0 program, the burden would have to be picked up by Germany and France and the latter is ill-positioned to do so. In some ways, short French bonds is a way to position for greater Italian and Spanish woes. And in this context, we note that despite the ECB-induced rally in Italian and Spanish bonds, the CDS prices are going in the opposite direction. Although there may be liquidity considerations, given that the sovereign bond market is being manipulated, the CDS market may offer a "cleaner" read of sentiment.

Another reason why the market suspects that where there is smoke there is fire is the borrowings from the ECB. Recall that the ECB's reserve maintenance period is a month-long. Yesterday was the first day of the new period. Usually the beginning of a period see slack demand as banks have the whole month to build their reserve position. However, yesterday borrowing from the ECB's marginal lending facility rose to 4.06 bln euros, compared with 147 mln euros the last day of the previous reserve period on August 9.

Recall too that the ECB charges 2.25% (annualized) for its overnight loans. This is more than 75 bp more than its main refinancing facility. The heavy borrowing would seem to suggest that something is amiss and it is not simply hoarding cash, given these rates.

Lastly, note while since late May the euro's correlation with the US S&P 500 has been fairly steady, since late May the euro's correlation with the financial sub-index of the Dow Jones Stoxx 600 has nearly doubled to stand now near 0.62.