Convergence in core-periphery sovereign credit spreads since 2012 would seem to vindicate
the raft of monetary easing measures deployed by the ECB to stabilise the eurozone. This is
only half the story, and the other half is decidedly negative.

The eurozone collapse in cross-border lending and holdings of debt securities is a
dangerous dynamic lurking beneath the surface. The left-hand chart below shows that the
aggregate of cross-border lending and debt holdings within the euro area has fallen to 30%
of GDP, from a peak of nearly 50%. In nominal terms, this is a massive €1.5trn liquidation of
intra-euro positions.

The pressure on banks from domestic regulators to reduce balance-sheet risk, coupled with
the realisation that a fully-fledged banking union with mutualised deposit insurance is a long
way off, has triggered a retreat inside national borders and fuelled the financial balkanisation
of the eurozone.

Central-bank liquidity pumping has suppressed volatility and engineered artificial stability.
With the recovery in economic activity and inflation emboldening the ECB and raising the
probability of further asset tapering, the risk of the current low volatility regime coming to an
abrupt end has increased.

(Click on image to enlarge.)

Source: Bloomberg, Macrobond and Variant Perception