France / Austria / Netherlands " FAN " coming into view as the new PIIGS ?

http://ftalphaville.ft.com/blog/2012/04/25/973811/rank-by-correlation-european-edition/

Rank by correlation, European edition

Posted by Lisa Pollack on Apr 25 12:04.

As markets ponder France’s post-election future, and the Dutch deal with the collapse of their government, some analysts are wondering which countries even qualify as being in the “core” of Europe.

In so contemplating, Divyang Shah, Global Strategist at IFR Markets, has put together this table of the correlations between the daily changes in the 10-year benchmark bonds of various countries, year-to-date (click to expand):

He’s highlighted a few that are particularly noteworthy, providing the following commentary:

Correlation analysis confirms a few truths about the eurozone sovereign debt market, but also points to two risks: 1) that Netherlands is close to being relegated from the group of countries regarded as core, and 2) France and Austria are close to being relegated from semi-core to outer peripherals.

FT Alphaville must have lost track somewhere… First it was “core” vs “periphery”, and that whole imagery of a core with satellites made some sense to us. Now we have: core, periphery, outer periphery, and semi-core? And did you remember to bring your skepticism-face to the office today?

Anyway, here are the implications of the correlations, celestial body by celestial body.

The Netherlands is looking wobbly.

What the correlations also reveal is that the Netherlands has a lower correlation with Germany and the UK, suggesting it is close to being relegated from the core group. The current focus on politics and fiscal austerity and the potential threat to its triple-A rating are real risks to the Netherlands remaining a core country.

France and Austria vs Italy and Spain.

While France and Austria are highly correlated with each other, they also show a strong correlation with Italy and Spain. This suggests that both France and Austria are close to being relegated from the semi-core to trading more like an outer peripheral.

Portugal and Ireland are still broken.

One final observation is on Portugal and Ireland, where correlations are generally close to zero even between the two. This likely reflects that both bond markets remain dysfunctional with still wide bid/offer spreads and very little liquidity/depth.

Given the above, Shah’s main observation is that the eurozone crisis gave birth to a tiered government bond market, and now it looks like a number of sovereigns could see themselves move down the ranks as investor sentiment shifts against them.

To state the flamingly obvious, correlation ≠ causation. Given that the instruments in question are all of the same type — 10-year government benchmark rates, eyeballing such a table is still an interesting exercise, in our view.

One final observation (emphasis ours):

The wide 10-year spread between gilts and bunds, at 50bps, currently does not make sense, especially when stacked against a 5-year CDS spread that sees the UK (64bps) trade through Germany (88bps).

To illustrate, we whipped up this chart:

The above is the Gilt benchmark less the Bund benchmark. When things were looking pretty horrifying in the eurozone in November, before the ECB stepped in with cheap three year loans that is, the relationship was the reverse, with the UK looking like a better credit. Some ECB loans later, and bam!, Bunds are back on the safe asset menu and looking yummy.

Meanwhile, in credit default swaps, at the 5-year point (and yes, the relationship holds for the less liquid 10-year too, so this is not about not about the difference in the length of the swaps/bonds):

Here we see that the UK started to look more creditworthy than Germany around fall of last year, and has been more convincingly so since the start of 2012.

Why could this be? Which is the better credit: the UK or Germany?

The disconnect is strange, and may, in part, have its routes in the different investor populations of the respective asset classes.

We’d posit though that this may be a question of currency. The benchmark yields for the bonds are for euros and pounds, but European sovereign CDS are denominated in US dollars. It could be that Germany is paying a bigger price than the UK, in CDS terms, because it has less control than the UK does on the movements of its currency relative to US dollars.

Strange one though. Further ideas and thoughts most welcome in the space below.