The week ended with a whimper rather than the bang we have become accustomed to. Indeed, the last few days have been untypical of what has been one of the most turbulent months in recent memory. The impending long weekend in the UK and UK is no doubt contributing to the tepid denouement. But events earlier in the week suggested that we were set for yet more volatility.
The tension between North and South Korea has been simmering since a South Korean warship sank in March, leading to accusations that a torpedo from the North was responsible. Blame was apportioned to Pyongyang with no equivocations this week, prompting the North to order its military to prepare for war. South Korea‘s spreads duly widened to 175bp, their widest level since July 2009. Japan, Korea’s neighbour, saw its spreads widen to 100bp, the first time it has reached this mark since March 2009. Most consider all-out war unlikely, and Korea’s spreads have recovered to around 133bp. But the unpredictable nature of the North means that there is potential for more volatility. China – effectively the North’s benefactor – will play a crucial role in dampening hostilities.
The Korea situation appeared to have only a transitory effect on risk appetite. After hitting the 130bp level on Tuesday, the Markit iTraxx Europe index has rallied and is now trading around 117bp, wider than the 113bp reached earlier today but still 5bp tighter than last Friday’s close. A recovery in the euro has helped sentiment in the region. The currency started the week at $1.25, plummeted to $1.21 on Wednesday before recovering to $1.24 today. Reports suggesting that China was reviewing its holdings of eurozone bonds contributed to the turbulence.
The sovereign debt crisis is, of course, at the core of the currency’s depreciation. This week there was a hiatus in the flow of negative news headlines, and volumes were lower than normal. Italy was a notable underperformer for most this week, with the markets a little nervous ahead of its major bond auction this morning. The sovereign’s spreads widened from 159bp last Friday to 215bp at yesterday’s close. The poor showing compared to the broader European sovereign market can be seen by looking at the chart above. The Markit SovX Western Europe index is trading at 132bp today, 8bp tighter than yesterday’s close. The difference between Italy’s five-year spread and the index was 77bp yesterday, the highest on record.
A solid bond auction today – though more so at the three-year than the 10-year – helped Italy to recover from its widening. The sovereign is trading around 200bp, and the whole sovereign market is tighter and outperforming corporates, albeit in low volumes. A combination of profit-taking and weak US stock markets has resulted in the rally losing momentum late afternoon. Next week we will see key economic indicators in the form of Markit PMIs, ISM surveys and the US jobs report. After a tumultuous month dominated by unforeseen events it will be interesting to see if fundamentals can finally start driving spread direction.
Markit’s Gavan Nolan wrote this CDS report