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European Credit Spreads Are Sending a Troubling Signal

Learn what "a key barometer of credit risk during the financial crisis" shows now

by Bob Stokes
Updated: April 19, 2017

Widening yield spreads mean investors are growing fearful about the future. In Europe, we're seeing bond market behavior that resembles what occurred before the credit crises in 2008, 2010 and 2012. Take a look at these two charts.

 

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[Editor's Note: The text version of the story is below.]

Many European bond investors are not so confident about the future.

Yield spreads between investment grade bonds and lower quality debt has been widening. This means investors in the shakier debt perceive a greater risk of defaults, so they're demanding a higher yield for assuming that risk.

For example, consider this chart and commentary from our March European Financial Forecast:

Credit Fears Spread

The bond market is behaving much as it did before previous credit crises in 2008, 2010 and 2012. … On February 7, French 10-year notes sank to an 18-month low, sending French spreads over German debt (top chart) to their widest level since early 2014. Dutch and Italian spreads (middle and lower chart) have likewise widened, recently touching respective three-year highs.

Keep in mind that Greece's debt crisis has flared up again, and France is one of Greece's main creditors.

But Europe's credit spread story doesn't end there.

Here's a chart and commentary from our April European Financial Forecast:

Fears of Bank Insolvency about to Surge Again

Libor-OIS displays a telltale five-waves-up, three-waves-down pattern since its 2015 low. …

Considered a key barometer of credit risk during the financial crisis, Libor-OIS essentially tracks the difference between a riskier interest rate (the Overnight Indexed Swap[OIS]) and one that is virtually risk free (the London Interbank Offered Rate[Libor]). A rising line, in other words, depicts rising fears about insolvency in the banking system, while a falling line shows that those fears are abating. After bottoming in 2015, the spread more than quadrupled into the third quarter of 2016 and then fell in three waves to its current level near 23.

In the meantime, our analysis reveals that Europe's overall financial picture is on the cusp of a major change.

For example, the volatility in European bourses has been extremely low. But, in our view, this is "the calm before the storm."

Our European Financial Forecast goes into detail about what we anticipate next.

european union

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