In a testament to the fact that, contrary to what Mario Draghi said in Washington last weekend, investors do not in fact believe that stocks can go down as well as up, there’s a mad scramble on Thursday morning to explain what, generally speaking, is a pretty mild decline in global risk assets.
U.S. investors woke up to a sea of red in Europe and also to a sharp decline in the Hang Seng that unfolded in the final minutes of trading and the chatter pretty clearly suggests that everyone is having a Captain Picard moment:
“Explanations” range from the plausible (Catalonia) to the conspiratorial (it’s all about the Black Monday anniversary) and some folks think maybe it would have been better if the PBoC’s Zhou Xiaochuan hadn’t said “Minksy moment” overnight on the sidelines of the Party Congress.
It seems more than a little suspect to suggest that Spain and Catalonia aren’t the proximate cause here. I mean, the worst case scenario has indeed materialized and while it’s difficult to sort things out because Europe was just opening when the news started to hit, euro breakup risk is back on the table and no one likes that – especially not a week ahead of an ECB meeting when Draghi is expected to outline the exit strategy albeit while simultaneously announcing the extension of the program.
“Funnily enough, for those still parsing overnight news for what matters most, I wouldn’t blame Catalonia,” Bloomberg’s Paul Dobson muses, adding that “Spain’s 10-year bonds have erased all their intraday declines and the spread versus German bunds is back to unchanged. For jaded, traders it’s becoming more like Cata-groan-ia.”
Maybe. But maybe Spanish bonds aren’t the best measure here. After all, they have an implicit guarantee from the ECB – “Whatever it takes” and all the money printing that comes with it.
In any event, we thought this was a good time to excerpt a couple of passages from a recent Goldman note on gold demand in Europe around episodic flare-ups in break up risk…
In Europe, the increase in retail demand in the aftermath of the financial crisis was primarily driven by fears of a breakup of the Eurozone and the abolition of the euro as a currency. Owing to the interconnectedness of the Eurozone, a political crisis in one of the member countries can lead to a spike in risk for the other countries in the bloc.
Since 2008 European retail gold demand has passed through several stages. In the immediate aftermath of the crisis, all government credit default swaps, including Germany, increased, pointing to a loss of confidence in the ability of governments to meet their liabilities (see Exhibit 35). When there is an increase in concerns over government solvency, fears of currency debasement also spike as people worry about the possibility of the government inflating away its debt.
The strong correlation between German CDS and European retail gold demand lasted until the second half of 2014, at which point retail investor demand became increasingly correlated to the spread between Greek and German bonds (see Exhibit 36). This occurred as political uncertainty in Greece led to concerns that it could opt to leave the Eurozone, creating a precedent for other member states.
In early 2017, an increase in European investor demand appears to have been driven by the risks surrounding the French presidential election and the potential for “Frexit” in the event of a victory for Marine Le Pen, leader of the populist Eurosceptic Front National (see Exhibit 37).
This suggests that Euro area gold demand tends to be driven by heightened political risk in one of its member countries, which could lead to the break-up of the currency bloc. To fully capture the different drivers of Euro area gold demand, we create a Euro area gold risk index. The index is based on the German CDS and spreads between Germany and Greece, Italy, Spain and France bonds. The CDS and spreads are scaled by their standard deviation from their average. After this, the square root of the series is taken to reduce volatility in the variables. The index is then calculated as the maximum of the standardized series. This ensures that the index always focuses on the series that signals the biggest stress in the system (see Exhibit 38).