Trader Talk

Euro Banks Surf the Yield Curve!


Surfing the yield curve: Someone is buying an awful lot of European debt recently, particularly at the short end. Huh? Isn't European debt toxic?

European Central Bank
Travelpix Ltd | Photographer's Choice | Getty Images

Well, sort of. But the European Central Bank will have a new long term lending facility (up to 3 years) that will soon come into effect. This was all part of the announcement last week.

Here's how it works: European banks can borrow up to 3 years from the ECB at 1 percent. They're going out and buying European bonds at, say, 5 percent yield. Voila. Surfing the yield curve ! Instant money! Sounds like guaranteed money, no? What's the risk?

The risk's not a riskless trade. What happens if there is a downgrade of European debt, which we have been waiting for all this week? Suddenly those bonds you bought at 100 cents on the dollar are trading at...80 cents on the dollar. What happens if you bought them with leverage? You have to put up more money.

Naysayers say not to worry, the banks will keep the debt at 100 cents on their books, even if it's trading at 80 cents on the dollar, because they believe they’ll be getting their money back after two years. Fine as long as there's no defaults.

There's another problem: Banks are already leveraged up to their eyeballs with European they're levering up more?


1. The euro is rallying, as are European bonds, with Italian 10-year yields now back below 7 percent.

2. The Shanghai stock market has rallied off its two-year lows, but now it's India's turn: The Bombay Sensitive 30 Index, the main Indian stock index, fell 2 percent to a two-year low.

3. Darden Restaurants shares down on light volume in pre-market trading after reporting second quarter profit in line with analysts’ estimates of 41 cents a share and $1.83 billion in revenue. Darden affirmed its 2012 forecast (after cutting guidance last week on Olive Garden woes). Darden reiterated weak traffic at its Olive Garden chain and noted costs for food rose faster than menu prices.

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