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Investors in Canadian bank stocks may be witnessing the resumption of an unfortunate post-financial crisis trend. The past four years have seen domestic bank stocks climb as 2008 recedes in the rearview mirror, only to be sideswiped by the European debt crisis.

The focus of European debt fears have moved from Spain to the much larger economy of Italy. A weak Italian bond auction Wednesday coincided with a two per cent fall in the S&P/TSX Bank Index.

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The preferred gauge of European financial stress over the past few months has been the spread – differential in yield – between German and Italian bond yields. The prevailing thinking is that German yields reflect economic conditions while Italian yields reflect the economy plus a premium measuring the probability of a euro zone break-up.

This chart shows the performance of the Italy to Germany spread plotted against the Canadian bank index. One clear trend is that changes in the spread are often followed by a similar move in Canadian banks after a lag period. This was particularly true in March 2012.

Financial conditions are constantly changing and the European Central Bank signaling its increased willingness to intervene in bond markets is a definite plus for investors in all global banks. But the significant move lower by the bank index in recent days suggests that the relationship can't be completely discarded yet, and that more volatility in the Italian political situation is likely to be met with weaker Canadian bank stocks.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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