How do sovereign debt crises happen? Not gradually, then suddenly. That’s the upshot of new research from Barclays, which has been trying to build a better measure of sovereign bond market stress.
Barclays’ gauge is framed on eurozone government bond yield spreads relative to Germany. The default benchmark, the ECB’s Composite Indicator of Systemic Stress, uses euro interest rate swaps. And, according to Barclays, it’s distorted by collateral scarcity in a way that bunds are not.
Both the Barclays and ECB graphs show spikes at all the obvious places (the euro area crisis, Italy’s political meltdown, Covid). Where they diverge is in year-to-date performance: Barclays’ lines showing much lower levels of recent anxiety in “semi-core” countries like France.
What’s happening here is that the ECB’s frames its methodology around the absolute value of euro swap spreads. But demand for collateral can widen the spread between swaps and government bonds, particularly at the core. Rate swaps also have to price in some risk of counterparty failure, so are not ideal whenever there’s a growing fear of bank runs.
By seeking to strip out these distortions, Barclays arrives at a metric showing crisis comes in like a wrecking ball…
.…from which it perceives “a non-trivial risk” of rapid fragmentation and a replay of the European sovereign debt crisis.
Other components for Barclays’ gauge are yield volatility, default risk as per the sovereign CDS spread, and depreciation risk as measured by the difference between the dollar and euro CDS, aka the quanto CDS spread. Here’s a breakout for Italy that shows spreads, volatility and devaluation all edging higher as default risk flatlines.
This lack of a clear warning is similar to all the previous times when there was a lack of clear warning, its team reasons:
Our indicator suggests sovereign market stress has increased visibly YTD, but remains significantly below the levels during the European sovereign debt crisis. This is consistent with the sell-off being primarily an orderly reflection of the changing monetary policy stance. Volatility has picked up substantially and spreads are wider. However, the level of these variables is still relatively low compared to the past, the CDS priced risk of default has not increased in any of the four countries, and redenomination risk remains very subdued in Spain, Belgium, and France.
Past experience, such as the sovereign debt crisis and the 2018 political crisis in Italy, shows that the market may very suddenly lose confidence in a non-linear way, even from relatively subdued initial levels of stress. This makes it very difficult to predict the timing of fragmentation in advance. At the same time, if fragmentation does occur, it may reach extreme levels very quickly, and this could be difficult to counter with all but the most forceful tools.