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Canadian bank investors, watch Spanish bonds Add to ...

Some important clues about what lies ahead for Canadian bank stocks may lie in Europe’s troubled periphery.

Over the past year, Canadian bank stocks and the Spanish bond market have closely tracked each other, with share prices of the Big Five banks rising and falling with tandem with certain movements in Spanish government bonds.

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Investors appear to be betting that Canadian banks will feel the pain of euro zone trouble or prosper from any resolution to the continent’s crisis. One big source of anxiety for banks worldwide is fear that countries such as Greece or Spain may leave the currency bloc, leading to widespread problems among financial institutions as they try to sort out the impact of new currencies and negotiate how euro-denominated debts should be repaid.

If the trend of the past few months continues, Canadian bank investors would be well advised to keep an eye on Spanish bonds, which provide a good barometer of financial stress in Madrid and within the euro zone.

Yields on the bonds tend to fall when anxiety about the euro zone eases and investors demand less of a premium to hold the securities. When markets grow nervous at the prospect the currency bloc may break up, yields shoot up as skittish investors pull money out of riskier investments.

Despite the ocean between them, the S&P/TSX Canadian Bank Index has followed the degree of yield curve steepness in the Spanish bond market with remarkable closeness over the past few months.

Yield curve steepness is the difference between the yield on the 10-year government bond and the yield on its two-year counterpart. The difference indicates how worried investors are that a crisis is imminent, with small differences suggesting higher anxiety.

The logic works like this: There is normally less default risk within two years than 10, so a government should typically be able to issue shorter-term bonds with lower interest payments than longer-term securities. But if the market believes trouble is right around the corner, the yield on the two-year bond will jump and the gap between the two vintages of bonds will narrow.

In May, two-year Spanish bond yields spiked as concerns grew that Spanish bank clients were moving their savings to perceived havens such as Germany and France. Fears of capital flight caused curve steepness to fall sharply. Canadian banks followed the measure lower, dropping 8.2 per cent for the same period.

Capital flight remains a major area of concern for Spain’s banking system. According to Jens Nordvig, an analyst at Nomura, Spanish banks are experiencing huge deposit outflows amounting to more than 50 per cent of the country’s total gross domestic product. The ability of Spain’s banks to lend has a direct impact on the country’s future economic growth, so concerns regarding bank balance sheets are immediately reflected in the market for Spanish government bonds.

A decision by Greece to leave the euro and regain some measure of monetary independence could prompt investors to pull more money out of other euro zone countries in distress.

That would put pressure on Spain’s already hard-pressed banking system and would likely trigger a rise in Spanish two-year bond yields. The result would be a decline in Spain’s yield curve steepness which, if current trends hold, will push Canadian banks stocks lower in sympathy.

Some observers feel a Greek exit has the potential to bring about a global banking crisis. “We think the shock to confidence in the euro zone would be at least as high as that of fallout from the Lehman Brothers collapse,” Laurence Boone, an economist at Merrill Lynch, writes. In such a scenario, he says, “funding markets are likely to be completely shut, even for the strongest banks.”

 
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