Yesterday, we compared rising interest rates on both sides of the Atlantic. In the U.S., the Treasury is competing for money with builders who expect big returns. In Europe, lenders are demanding more return to lend to governments like Italy's, because the risk is rising.
This is the boom loop versus doom loop we've been talking about since March.
In America, compute generates revenue, revenue funds more compute, and compute generates more revenue. In Europe higher energy costs squeeze the budgets of the more fiscally fragile countries, which pushes up their borrowing costs, which threatens solvency, which pressures bank balance sheets, which tightens credit, which weakens the economy.
Today, the market repriced the doom loop.
Italy's and France's 10-year yields went up. Germany's went down. That's money leaving the fiscally fragile countries, and moving to Germany (relative safety).
If we look at the gap between Italian and German government bond yields, it hit 116 basis points today, the widest of the year. It was 63 the day before the Iran war began.
This chart above signals rising probability that sovereign debt inside of Europe could become a problem again (a revisit of 2011-2012 sovereign debt crisis). The ingredients are in place for it.
With this spread rising, the euro broke below 1.13 to the lowest level in 17 months.
And European bank stocks fell 3.9%, their worst day since March 3, the first week of the war.
Why the banks?
European banks are among the biggest owners of their own governments' bonds. When those bonds fall, the banks fall with them. That's the link in the loop where sovereign stress becomes banking stress.
What's driving it? Energy price inflation.
With that, the U.S. is telling Europe to release their emergency diesel reserves rather than rely on U.S. exports. Trump's threat is a ban on U.S. diesel exports, which would relieve price pressure at home. China piled on today by halting fuel exports for October.
This all comes as the report on September inflation for the euro zone is due tomorrow morning. It's expected to come in hot at 3.6% — because of energy prices.
That puts the ECB in a bind. The energy market is doing the tightening. The bond market will do the strangling. And the ECB, to this point, has been tightening that grip, with two rate hikes since June.
Order in Europe hinges on the ECB's ability to convince markets it can keep the sovereign debt market stable. But even the U.S. is perceived to be at risk of losing control of its bond market, and it has the firepower of the world's reserve currency.
The ECB, on the other hand, just has the untested threat that it is the backstop, via its "anti-fragmentation tools. We will likely find out soon whether it can back it up.
