Risk of a Haircut Weighs On Euro


The US dollar has recovered from the decline seen in North America yesterday against the major European currencies.   The take away from the price action is not however one of consolidation, but rather that good dollar buying emerged on the pullback.  The EMU situation is continuing to deteriorate.  Good support was encountered yesterday just below $1.3300, but there is really little to hang one’s hat on until $1.3200.  In the UK, while the risk of a hung parliament has long been discounted, but many of those momentum players and contrarians playing sterling from the long side have met a formidable obstacle at $1.55 and 0.8600 against the euro.  Watch $1.5340, roughly the 20-day moving average, below which sterling has not finished the North American session below since 29 March.  The yen is benefiting in this environment, but the dollar’s push back form the JPY94.35 high yesterday has still been fairly shallow thus far.  However a break of JPY93.60 would suggest a near-term high is in place.  Dollar-bloc currencies and most emerging market currencies are also softer today. 

US stocks, which have advanced a little more than 70% of the time since last July’s lows, faltered yesterday and Asian and European bourses are lower today.  The MSCI Asia Pacific Index slipped 0.2%, the Nikkei actually posting a 0.4% gain.  It was led by a big rise in industrials and smaller gains in consumer goods and basic materials, which offset the drop in oil, gas, healthcare, and financials.  The Shanghai Composite fell 2% and posted its lowest close in late September ‘09.  European bourses declined around 1%, with the southern markets among the hardest hit.  Moody’s downgrade of some Greek covered bonds has given the Athens market another kick.  The 2.7% decline is led by telecoms and financials.  In the US, almost an eighth of the S&P 500 report earnings today. 

There are two key and interrelated points about the global bond markets today.  First, pressure is relentless in the peripheral European bond markets.  Greek 10-year is a bit firmer, but Portugal is in the line of fire and 10-year yields are up 22 bp today.  Italy, Spain and Ireland’s 10-year bonds are falling.    The pressure is much more severe in the 2-year space.  Greek 2-year yields are up another 121 bp; the other peripheral 2-year yields are up 15-20 bp.  The poor reception to the poor reception to the Italian bill auction did not help matters.  Second, pressure is encouraging a safe haven bid for German bunds and US Treasuries, and this may still ensure a good reception at the sale of $44 bln of 2-year notes today, even though there is not much of a concession built in.  Canadian bonds may also benefit from a safe haven bid.

Currency Markets                                                                                       

The main talking point for many today is the ongoing tension between Greece and Germany, with the consequence being felt in the debt market and the inability of the euro to sustain even modest upticks.  However, perhaps rather than the apparent differences, what is really going on is being driven by their similarities.  Specifically the latest opinion polls seem very clear and in agreement.  The majority of Germans do not want to bailout Greece and a majority of Greeks do not want foreign assistance.  What does this mean?  It means the unthinkable has become thinkable:  restructuring.  The continued widening of spreads against Germany reflects this.  Suppose, for example, the goal is to bring Greece’s debt/GDP ratio to 60%, as the Stability and Growth Pact mandates.  In lieu of currency devaluation, many investors appear to be taking debt deflation more seriously.   All stake holders may have to take a hair cut and how the costs are distributed is what the European politics may determine.

Greece will have to lower its standard of living.  Some reports suggest that Greece may be facing demands to raise the retirement age to 67 from 62 and abolish the two months bonus for government workers.  Greece also faces a deep economic contraction and rising levels of unemployment.  Countries, like Germany, who export goods to Greece may see weaker demand.  Bond holders may have to take a hair cut.  To reduce the debt/GDP level to 60 % requires cutting the debt in half.  A 50% haircut is steep compared with other sovereign debt restructuring. .  The current 2-year Greek-German spread is consistent with about a 25% chance of a 50% haircut or about a 33% of a 40% haircut.  There seems to be a growing realization that the bond holders are primarily banks and much of the EU/IMF funds will eventually wind up in the banks’ vaults.  Greece is really not being bailed out.  At best it is being forced to boost its savings so it can service its debt, and lent money so it can service its debt.  The backstop for Greece may really be another backstop for European banks.

Next month’s UK election continues to be a major talking point as well.  On balance, the polls continue to point to a Labour-Lib-Dem coalition.  On one hand, Labour seems more willing to agree to electoral reform than the Tories.  On the other hand, Lib-Dem’s Clegg is insisting that if Labour actually comes in third in the popular vote, he could not accept Brown as Prime Minister.  The third television debate is set for Thursday.  The risk is that the attention the UK election is receiving is overshadowing a very important state election in Germany.  North Rhine Westphalia goes to the polls on May 9th.  The polls continue to show the governing CDU/FDP coalition losing its majority.  If it were to lose its majority, Chancellor Merkel would lose her majority in the upper chamber of the German parliament.  This would undermine her agenda, which includes cutting taxes.

This may in part be influencing the German government’s stance vis a vis Greece and it appeared that the French Finance Minister hinted at this yesterday as well.  Merkel tried to justify support for Greece on the grounds that it is really about the euro:  “We’re not doing this because we believe Greece needs help.  We’re doing it because we’re interesting in the euro’s stability.  We can’t idly stand by when our currency comes under threat.”  Is the euro really under such a threat?  The Bundesbank’s Weber, and a leading candidate to replace Trichet at the end of his term, said point blank that there is not credibility issue for the euro.   While the euro has declined about 7% since the start of the year, it remains by the OECD’s measure of PPP is still more than 12% over-valued.   A weaker euro is part of the solution for Europe, not part of the problem.

Upcoming Economic Releases                                                                       
The US reports the S&P/CaseSchiller home price index for February at 10:00 EST/14:00 GMT.  The consensus expects the first positive year-over-year reading since late 2006.   The Richmond Fed Manufacturing Index and Conference Board’s consumer confidence measures are out an hour later.  Small gains are expected.  The FOMC and Brazil’s central bank begin two-day meetings.


This was the BBH CurrencyView by Marc Chandler. Marc is the Global Head of Currency Strategy at Brown Brother Harriman. For more of BBH’s currency views, visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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