CITI: Cracks Are Starting To Appear In Europe, And One Market Is Particularly Concerning

The big rally in European risk assets like stocks took a breather late last week.

Citi strategist Robert Crossley is watching flows in sovereign bond markets, and he warns that problems are surfacing in Europe.

In a note to clients titled "Cracks starting to appear in Europe," Crossley looks at demand for European sovereign debt – which just turned negative for the first time in three months.

Although the drop in demand has been led by a retreat from safe-haven investments in "core" sovereign debt – like that of Germany – the issue is where the money has been going.

Certain sovereign debt markets in the euro periphery – Spain, for one – have been the big winners. Demand for the periphery remains positive, notes Crossley, but that could change pretty quickly:

Although demand for peripherals has fallen, like the core, it remains positive. It is this cumulative yield-seeking positioning that concerns us in the current environment where the risk-on mood is turning and investors are reassessing the risk-reward of risk positions with the wash-out of carry trades in short-dated EUR swap forwards, a strengthening FX rate, and risks surrounding comments coming from the forthcoming ECB meeting.

Sure enough, there is one market in particular that has Citi particularly wary: Spanish sovereign debt.

As the chart below shows, and as Crossley characterizes it, "buying has been disproportionately large in Spain" over the past month as investors have embraced the risk rally full-stop.

"That flow," Crossley writes, "makes us very wary of the potential for the current risk-off mood to gather damaging momentum."

As Crossley hinted, much will turn on Draghi's response at Thursday's ECB press conference to any questions about the recent strength in the euro and the corresponding sell-off in short-term and safe-haven interest rate investments.

Morgan Stanley interest rate strategist Laurence Mutkin agrees. He writes in a note to clients, "Our economists doubt [Draghi will] lean heavily against the rise in rates, but we hope he'll avoid the mistake his predecessor made in blithely characterizing the rise in EONIAs after the 1y LTROs’ expiry in 2010 as being no more than evidence of the improving health of the banks."

READ MORE: Morgan Stanley Is 'Getting Worried' About Europe Again >