Asia Unhedged hasn’t cared whether Greece comes to terms with the international institutions, or drifts off into the Aegean. Grexit, Schmexit is how we have viewed the matter: a carnival sideshow in world finance, an amusing soap opera, but without broader consequences. As the moussaka hits the fan, southern tier sovereign spreads have widened a bit, as in the chart below showing the difference in basis points between the German 10-year and, respectively, the Spanish and Italian 10-year note. The usual suspects, to be sure, are talking of contagion. Asia Unhedged sees the matter much more simply: If Europeans think that Grexit will cause a major crisis, why have they been selling the safest available store of value (Bunds) rather than buying them?

Absolute spread between German 10-year and Spanish and Italian 10-year bonds

That’s the usual way to reckon spreads between sovereigns, but it is not the theoretically correct way. More precise is the percentage difference between yields on sovereign bonds, that is, the proportional difference between Germany and Italy.

Proportional spread between German 10-year and Italy  10-Year

This looks quite different: in April, when the German 10-year note approached zero, the Italian 10-year note yielded 20 times as much. In proportional terms, the Italy-German spread is close to its all time lows.

During the past year, the spread between German and Italian 10-year notes has tracked the absolute level of the German 10-year yield with about 60% accuracy.

Regression of German-Italian 10-year spread in bps vs. German 10-Year Yield

This tells us that the most important development is NOT the widening of the absolute spread between Germany on the one hand and the southern tier countries on the other, but rather the OVERALL rise in yields.

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