As the eurozone and the overextended banks and governments on its periphery continue to strain and buckle, global financial markets appear, at best, vulnerable to a repeating pattern of sympathetic tremors.
But compared with the Greek episode last spring, the most recent flareup, which culminated in a $100 billion rescue deal for Ireland at the end of November, produced only mild ripples in bank credit-default swaps, or CDS, and interbank lending markets (see charts below).
An average of five-year CDS for banks on the panel that supplies quotes to determine the U.S. dollar London interbank offered rate, or Libor, peaked at about 180 basis points in early June. (CDS prices reflect the cost of a wager that guarantees the face value of a certain amount of debt if the borrower defaults.)
That coincided with a spike in the spread between three-month Libor and the overnight indexed swap rate for the same term. Widely used as a barometer of market perceptions of bank health, since no principal is at risk in interest rate swaps — OIS lets counterparties exchange a fixed yield for the average federal funds rate over a stated term — the gap jumped from around 10 basis points in the first part of the year to about 30 to 35 basis points from late May to late July.
The spread subsequently drifted back down to around 10 basis points before ticking up a couple of basis points this month after the shock waves from Ireland sent the Libor panel CDS average gyrating to a peak of 141 basis points at the end of November. (Libor is based on daily polls in which large banks are asked to submit rates at which they think they could borrow; it closely tracks market rates, for instance, for certificates of deposit and commercial paper issued by financial companies.)
Reaction in stock prices last month was also relatively tame, perhaps reflecting sentiment that the authorities in Europe will ultimately succeed in containing the crisis or, at least, that disaster was not near at hand. Some analysts have further said that money market funds' insulation from the Continent's periphery is a factor behind the apparent equanimity in Libor.
Foreign issuers' share of financial commercial paper has been growing lately — by almost 8 percentage points since the end of April, to about 43% in mid-December, according to Federal Reserve data. But in a report this month, Barclays Capital estimated that exposure to banks in Italy and Spain — the two largest economies in the eurozone generating the most worry — made up less than 5% of assets at a group of large funds.
Nevertheless, it is worth being mindful of "signs that credit concerns have increased enough to change money fund behavior and cause a broader-based choking up," Barclays said, and with funds' large vulnerability to Europe generally, fears are likely to reignite.
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