This correction was not surprising. CDS spreads have improved significantly since last September when the European Central Bank (ECB) announced the Outright Monetary Transaction (OMT) policy in support of eurozone members. Italy and Spain CDS had declined from more than 450 bps in late August 2012 to as little as 220 bps in early January 2013, before widening to just shy of 300 bps in reaction to the Italian election.
But this isn’t as dramatic as it sounds. Italy and Spain CDS spreads were susceptible to a correction because the recent improvement in CDS spreads for both countries lacked validation from fundamental economic indicators. For instance, Italian unemployment increased to a cycle high of 11.2 percent at the end of 2012 from 10.9 percent in September, while Spain’s unemployment rate deteriorated to 26.1 percent from 25.7 percent over the same period.
As long as unemployment levels remain this high in Italy and Spain, there will be a firm 200 bps floor in the CDS market for both countries, which will leave the markets vulnerable to periodic corrections. The good news, at least for the moment, is that unemployment appears to have stabilized in these two countries in the final two months of the year. This is a reason to be optimistic that conditions may improve further in the months to come, potentially setting the stage for additional improvement in sovereign credit conditions.
The events of the past few weeks in Europe illustrate some high-level similarities with the situation in the U.S. Divided governments in the U.S. and Italy need to find common ground in their efforts to rein in their long-standing unsustainable sovereign debt accumulation. The Federal Reserve and the ECB are doing nearly everything in their power to sustain economic growth, buying time for fiscal policymakers to address very difficult policy issues.
But the government divisions in Italy, which will likely lead to painstakingly slow policymaking, may actually turn out to be positive if they force all opposition parties to reach a consensus on the need to maintain some version of a path toward austerity. This is not unlike the painful process unfolding in Washington, where ideologically opposed political parties are being forced to address the unsustainable trajectory of U.S. deficit spending. Global political theater will turn out to be worthwhile if it ultimately results in sovereign governments steering toward healthier and more sustainable fiscal policies.
By supporting the fledgling recovery in housing, the Federal Reserve is purposely prioritizing the U.S. housing market as a means of promoting economic growth, while the ECB has chosen to underpin the broad European economy and financial system through its OMT program. Both programs have recently produced early evidence of success in 2013. U.S. new home sales shocked on the upside in January, coming in at 437,000 units annually compared with the expected 380,000 units, which is the strongest sales rate recorded since July 2008. In Germany, Europe’s largest economy, the IFO Business Survey Index unexpectedly rose by three points to 1.07 in February, providing some hope that stability and improvement in Germany might somehow spread through Europe over the course of this year as long as the ECB continues to be successful in mitigating sovereign credit risk concerns generally. The common challenge facing all of our elected officials is to reach a compromise that produces credible long-term solutions while simultaneously avoiding short-term policy blunders. As events this week suggested, trouble on either side of the pond can very quickly have ramifications on a global scale.
Thompson is managing director, S&P Capital IQ Global Markets Intelligence.