EU bond spreads and currecny markets

There has been an appreciation in some emerging market currencies while the value of the EUR has actually declined. The EUR was supposed to be the safe substitute for the dollar as a reserve currency. The story now seems to mixed as sovereign risk is becoming more apparent in the EMU.

The EUR is a liquid and deep market with better developed capital markets than Japan, yet the dollar rally has been mostly against the EUR. Their liquidity is being called into question because there is no way to solve country-specific crises in the EMU. There is no organization to provide stand-by credit accent the ECB. Th ECB has loosened its collateral standards through 2010, but president Trichet also stated that it would revert back to pre-crisis levels of A- ratings. Currently they will accept BBB-ratings but there are some EMU members such as Greece where this may be a stretch at the end of the year. The EUR capital markets may not be as liquid as perceived which may make the dollar more attractive.

A key reason for this decline in EUR demand could be associated with the greater sovereign risks in EU bond markets. Greece clearly is a poster child for greater risk differentiation but we are seeing greater spread differences all across Europe relative to Germany. The ECB has been tracking these developments, see vox.org piece, What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09 ( Maria Grazia Attinasi, Cristina Checherita, Christiane Nickel,).

They find that the international risk aversion may be the key explanation for the spread dispersion but the second most important variable is the fiscal position or risk within the sovereign. The greater differentiation in the market translate to less liquidity and a general aversion to the EMU which we have not seen in the US. Hence, there is less substitutability from dollars to EUR. Even with the US headways against the dollar, there could be a the makings of dollar rally if the confidence in sovereign risk further declines.