Great Graphic: Euro Remains Decoupled from Peripheral Spreads

The 10-year German bund yield dipped below 1.0% briefly today for the first time, encouraged by the unexpected contraction in Germany's Q2 GDP. Ideas that the area's stagnation in Q2 coupled with still no signs that inflation has bottomed, fans speculation of new initiatives by the ECB, which will likely include asset purchases support European bonds. In addition, US yields have not found any traction either. The 10-year yield is straddling the 2.40% level, pulled down by disappointing retail sales data and the unexpected rise in weekly initial jobless claims to six week highs. The projection that the US economy had ratcheted up to somewhat higher growth level after the sharp contraction in Q1 is being rethought.

The euro's resilience until early May confounded policy makers and investors. It took place along side a decline in peripheral yields in absolute terms and relative to Germany. The idea was that international fund managers and leveraged participants were under-weight the euro area, and amid signs that the cyclical low was in place, with the ECB's pledge to do whatever it takes to ensure the survival of EMU, they poured back in. Peripheral bonds offered a bigger bang for the buck.

However, that was then and this is now. Since the Draghi hinted at lower rates, asset purchases, and stepped up his effort to talk the euro lower, the relationship between the euro and the peripheral spreads has changed. This Great Graphic, created on Bloomberg illustrates this point.  The white line is the premium Italy pays over Germany to borrow 10-year money.  The yellow line is the premium Spain pays over Germany on 10-year bonds.  The green line is the dollar against the euro (an inversion of the way it is conventionally quoted) to help illustrate the point.   

It shows how the dollar fell against the euro as a function of the narrowing of the premium over Germany. Since early May, the dollar has risen regardless of the direction of the spreads. Several large asset managers publicly suggested that rally in the peripheral bonds had stretched valuations. 

There also was a sharp reversal of sentiment among speculators.  In early May, speculators in the futures market were net long about 25k euro futures contracts.  As of August 5, they were short 129k contracts. This reflects entirely the amassing of a large gross short position.  It has risen to 184k contacts from around 80k in early May.  

We had anticipated a corrective bounce in the euro, but had also expected that US Treasuries would not spend so much time below 2.50%.  The euro rose to $1.3415 yesterday from $1.3333 in the middle of last week.  Although it has not taken out that high today, the real news is that it did not sell-off in response to the poor Q2 GDP data earlier today.  Still,  the short-covering rally remains subdued, and not regardless of how short the speculative market is, it still seems inclined to sell into even modest euro upticks.