Skip to main content

The Deutsche Bank AG, logo sits illuminated on the bank's headquarter offices at night in Frankfurt, Germany, on Wednesday, Jan. 27, 2016.Bloomberg

The summer and fall of 2012 was the last time Canadian investors were forced to care about European markets. A burgeoning debt crisis centred in Spain rocked the domestic and global banking sectors, creating significant portfolio losses in a sector considered safe. Are we there again? The carnage in the European bank sector suggests we're heading that way.

The European banking sector has been among the worst-performing asset classes on the planet this year, falling harder than either the Shanghai composite or the energy sector, according to Credit Suisse research. Deutsche Bank AG has been hit particularly hard, dropping 27 per cent year to date.

Canadian investors learned in 2011 and 2012 that when stress on the European banking sector gets severe, the interconnected nature of the global banking system results in domestic bank stocks falling in sympathy.

The accompanying chart shows the S&P/TSX bank index plotted against the average value of credit-default swaps (CDS) on investment-grade European bank debt – essentially the cost of ensuring against debt defaults. The higher the cost of insurance reflects perceived financial weakness in the banks, and a higher likelihood of banks defaulting on their debt issues.

The lines move in opposite directions for virtually the entire period since 2011 – Canadian bank stocks fall as European CDS rise. The most obvious example is the period between April and November, 2011, during the lead-up to the first stage of the European debt crisis. The Canadian bank index plummeted 19 per cent as the average euro bank CDS climbed 213 basis points.

At this point, we are nowhere near the level of credit stress in either 2011 or 2012. CDS currently cost 118 basis points (which means the cost of insuring $1,000 in bank debt against default is $11.80) which is far lower than the 348 basis points in 2011.

Recently, however, Canadian bank stocks have been climbing while CDS contracts have been increasing in price – a break in trend and a divergence on our chart. The historical relationship suggests either a recovery in European banks, or a period of significant weakness in Canadian bank stocks.

The reason for concern is that negative interest rates on European sovereign bonds are increasingly prevalent and form a huge hurdle to regional bank profitability. Deutsche Bank's research team notes that falling interest rates attract investment into bonds. Faced with negative interest rates in the short term, investors buy longer-term bonds with positive yields, pushing the bond prices higher and the yields lower.

The end result is an extremely flat yield curve that makes it hard for banks to make money. The core business of lending is to borrow funds at short term rates and then lend them to clients at long terms rates. The difference in what a bank pays in short-term interest and receives in interest payments at longer term rates, makes up their profit. This profit is meagre if the yield curve is flat and there is little difference between short- and long-term rates.

U.S. and Canadian bank stocks both led their respective markets lower Monday, providing further evidence that growing stress on the global banking sector is a theme to watch closely in the coming weeks.

Follow Scott Barlow on Twitter @SBarlow_ROB.