The speculation surrounding AI outcomes (ROI, competitive industry destruction) has been noise.
The shock-risk signal is in Europe, where the vulnerabilities we've discussed in these notes are beginning to show up as cracks.
The euro has broken down technically and followed through today with another big down leg.
The key spread between Europe's weakest major bond market (Italy) and the anchor (Germany) widened.
The vulnerability in European banks showed up — a 4.5% decline today vs. just a 0.7% decline in U.S. banks (a 3.8%+ widening of that spread).
The latter two are where the "doom loop" still exists. It's the same dynamic that almost took Europe down in the Global Financial Crisis. European banks are loaded (still) with sovereign debt of fiscally weak European sovereigns — those at risk of insolvency when debt service costs rise (i.e. rise in interest rates).
With that, as a proxy on how much risk is getting priced into the European sovereign debt market (expressed in capital outflows from the bond markets of fiscally weaker constituent countries of Europe), we'll keep an eye on the spread between Italian and German 10-year yields.
It closes today at 71 basis points. Again, it's widening, which means it's moving in the direction of the elevating risk theme, but the spread is very narrow — which could mean it's early.
As you can see in the chart, this spread widened to 250 basis points back in 2022.
What was happening at the time?
Russia invaded Ukraine. Oil prices spiked from $90 to $130. Natural gas prices ran up from $4 to over $9. The spike in energy prices fueled inflation in Europe, crushed growth, the euro, and led to a capital flight OUT of the bond markets of the weakest links (which included Italy).
Where did the money go that was leaving Europe? The U.S. — into the dollar/dollar denominated assets. It was a (global) flight to safety.
So, there are obvious parallels to 2022. But this energy shock could be more severe — the Strait of Hormuz carries five times more oil than was disrupted in Russia's pipeline in 2022. And Europe's primary back-up, it's nat gas source, Qatar, has halted production.
With all of this in mind, European leaders have exacerbated the threats to their own stability in recent days, by doubling down on policy divergence with the U.S.
