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February 12, 2016

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The toxic twins are back

The markets yesterday gave the eurozone a triple-whammy: on sovereign spreads, on inflation expectations, and on the banks. 

While everyone was focusing on the banks specifically, it is once again the interaction between banks and sovereigns that spooks the market. Sovereign spreads have been rising throughout the week. We are not at the levels seen during the peak of the eurozone crisis, but investors are now clearly distinguishing sovereign risk across eurozone member states. Italy's 10-year spread was at 1.513% this morning. Spain's is a fraction higher, but the biggest increase happened in Portugal, where it is now 3.71% after shooting above 4% yesterday. This is a critical level for a country that is hardly in a good fiscal position, and this in a deflationary environment.

Much less reported but equally scary is the fall in market-based inflation expectations. The 10-year swap rate has now fallen below 1% for the first time (see our tables below). The 5y/5y forward rate - which technically ignores the next five years - stood at 1.4409%, another record low as well, and clearly deanchored from the ECB's inflation target. We personally have never placed much emphasis on market-based inflation data, even less on survey of professional forecasters, but we know that the ECB has. In any case, we can conclude that markets no longer believe the ECB's inflation target. Nor do we. 

Unlike last year, there is also no relief from the exchange rate. The euro traded at close to $1.13 this morning. More importantly, the nominal effective exchange rate of the euro keeps on rising. To put this into perspective, here is the euro's trade-weighted exchange rate chart for the last two years - against the eurozone's 19 largest trading partners. We are not back to pre-QE levels, but in a world where everybody tries to devalue, the exchange-rate channel is becoming less effective.

EER-19 Daily Effective Exchange Rate

Source: ECB

Some market participants were spooked by the rate cut of Sweden's Riksbank yesterday, which lowered its repo rate from -0.35% to -0.5%, together with an announcement that there was scope for further rate cuts. The central bank said that it is previous inflation forecasts had proved too optimistic. The Riksbank also said that it would investigate whether to underpin its lower interest rates with other policy decisions, which might include an extension of its QE programme or foreign exchange interventions.

Our other stories

We also have stories on the eurozone financial sector - it's not just Deutsche Bank that is in trouble; on the eurogroup forcing Mario Centeno to pledge a plan B; on Hollande's uninspiring cabinet reshuffle; on the latest Brexit negotiations not going well; on Thomsen's views on Greece; and on the nearing end of the €500 banknotes.

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