Eurozone core splits in half

France and Germany have always been at the core of the eurozone, and the EU project as a whole.

But the core is showing signs of splitting in half, leaving Germany as its sole member. The latest figures show that the French economy is in a tailspin - the Markit Flash PMI for February came in at 42.3, down from 42.7 in January and the lowest reading for nearly four years. This indicates an economy in contraction.

And it doesn't look like it is going to get much better. EU forecasts published on February 22 indicate that the French economy will grow by just 0.1% in 2013, a downgrade from its previous forecast of 0.4%.

The contrast with Germany is stark. The Markit Flash PMI for February came in at 52.7, down from the previous month, but still indicating that the private sector is growing at a solid pace. The divergence between the French and German PMIs is now at its largest since the survey began in 1998.
If anything, it is likely to get worse - the German economy is expected to grow by 0.5% this year, according to EU forecasts.

So, one might expect that the sovereign CDS spreads of both countries have responded in tandem. But this is not the case - France's spreads have been trading in a tight range around 80bps since the beginning of the year, while Germany's CDS haven't veered far from 40bps. The 40bps differential is modest compared to the 120bps gap seen last May, when both sovereigns were trading close to record wide levels.

What can explain this apparent lack of responsiveness to economic data? First, it should be remembered that CDS are used to hedge against the risk of default and speculate on a country's creditworthiness. They are tradable instruments, not economic indicators. Despite France's economic malaise, the risk of default remains very low.

Secondly, the main tail risk that could conceivably have led to a possible default of a major EU country has been quelled, if not removed completely. The ECB's commitment to the irreversibility of the euro, along with its Outright Monetary Transactions bond buying programme, has greatly reduced the probability of Spain or Italy defaulting. The contagion and the inevitable break-up of the eurozone now look far less likely to happen, at least in the near-term. It will take a major shock to shift French and German CDS from their current, comfortable ranges.

Spreads in the corporate world have also shown resilience to the economic stagnation. The Markit iTraxx Europe closed the week at 114bps, just 1.5bps wider than where it started the week.

However, idiosyncratic risk has returned in the form of leveraged buyouts, leading to dramatic widening in spreads on target companies. Virgin Media, which was acquired by Liberty Global in a leveraged deal earlier this month, saw its spreads widen from 250bps to almost 400bps overnight. US food group Heinz suffered a similar fate, its spreads widening from 44bps to over 200bps after it was bought by Berkshire Hathaway and private equity house 3G.

These are huge spread movements by any era's standards.And it isn't just the spreads that saw major shifts. Liquidity in the LBO targets was also affected - the number of unique daily quotes in Markit's CDS service for Virgin Media increased from 58 to 233 after the deal was announced. Similarly, Heinz went from 54 to 272 quotes.

Virgin's bid/ask spread actually compressed after the LBO announcement, an impressive show of liquidity given the sharp widening in CDS levels. Since then, the number of quotes for Virgin have fallen back to pre-deal levels, while Heinz has stayed at around 200 quotes. The latter company was the third most active name last week, according to DTCC data.

It is too early to say if we are at the start of another LBO boom. But it is likely that the inevitable speculation will cause persistent fluctuations in the CDS market that will affect both spread levels and liquidity.

Download full article