European tail risks have clearly diminished, though this has had the perverse effect of deteriorating credit conditions for the euro area as a whole.
A fter a sharp fall earlier this year, our measure of global credit impulse has troughed in the last few months. This suggests that economic activity should stabilize in the fourth quarter. But after recent strong rallies, risk assets seem to be well-priced for this stabilization and then a resumption of growth in early 2013.
That may be too optimistic.
True, the reduction of tail-risk in Europe is very welcome, but it has come at a price. It has perversely pushed up long-dated bond yields in the core economies as safe-haven flows have reversed. The upshot is that the all-important weighted average yield across the euro area has increased. Therefore, somewhat paradoxically, credit conditions for the euro area as a whole have actually deteriorated.
As we recently highlighted, with Europe now facing a double-dip recession, policymakers will likely need to do more, regardless of tail risks.
Bottom line: Only a benchmark cyclical weighting in European risk assets is warranted.