Ireland Announces, Euro Tumbles

Highlights
The US dollar continues its rally with the largest movements against the euro as the market is clearly disappointed with the rescue package of Ireland.  Despite a three year high increase in euro-zone confidence, the euro continues to suffer, reaching recent lows below $1.32 and nearly retracing 50% of June’s lows along with its 200-day moving average. Meanwhile, sterling weaknesses continued, reaching a session low of $1.556 on the back of light economic data, notably a drop in mortgage approvals.  And following a dip in October retail sales the yen is flat, maintaining the JPY84 level.  But recent price action has been driven not by data but by events and we see this theme continuing over the next week. Elsewhere, a light statement by the Reserve Bank of Australia (RBA) Governor Stevens led to extended lows for the Australian dollar following a brief recovery in risk appetite and a short-lived rally in the euro. 

Global equity markets are mixed following the news of the bailout of Ireland.  For one, Asian stocks are headed higher with the MSCI Asia Pacific index up 0.6%.  The Nikkei is up 0.8%, led by gains in financials.  The Shanghai Composite, however, is down 0.1% with large losses in materials. In Europe stocks were weaker with the Euro Stoxx 600 down 0.4% led by a 1% drop in technology.  Meanwhile, the FTSE and Dax are both down 0.4% and 0.7% respectively, led by losses in telecommunications and consumer goods. 

European sovereign bonds yields continued to increase with the Spanish 10-year now taking the leading, up nearly 14bp over contagion concerns, despite the €85bln rescue package for Ireland. With Greece and now Ireland taken out, the bond market vigilantes have honed in their sights on Spain, Portugal and even Italy and Belgium.  Today, for example, Italy’s 10-year borrowing costs rose 11bp at a sale of €6.8bln.  Italy’s Treasury sold €3bln of securities due March 2021 to yield 4.43%, compared with 3.89% at a sale on October 28.  The Treasury also sold €2.5bln of securities due in November of 2013 to yield 2.86%, more than the 2.32% at the October auction.  The Treasury also auctioned €1.34bln of floating-rate notes due 2017 with a yield of 2.3 while, on the whole, originally set a maximum of €7bln for sale.  At the same time, Belgium did not fare any better, raising only €2.0bln, only halfway to its intended target of €1.5-2.5bln.  The weak auction, in fact, led the Belgian-German 10-year spread to widen by more than 100bp, nearly a two-year high, highlighting that the euro-zone crisis is far from over.  Otherwise, German 10-year yields were up 1bp with US 2-and 10-year Treasuries up 2bp and 1bp.

Currency Markets

The global capital markets are not impressed with the European efforts to stabilize the situation.  The euro continues to struggle to sustain even the most modest of upticks and the relief in the European sovereign bond market is hardly convincing.  The €85bln package provided to Ireland is less than meets the eye insofar as 17.5 bln comes from Ireland’s pension reserves (representing an additional €10bln more than was previously committed).  The average interest rate of 5.8% appears to be a compromise as reports indicated Germany wanted a more punitive rate of 7% and Ireland wanted 5%.  Talk on Friday was that the rate could be closer to 6.7% yet the 4 1/2 year extension of Greek’s EU debt was an unexpected and likely paves the way for the rumored extension of the IMF debt as well.  Europe also formalized the European Stability Mechanism (ESM) that will replace that European Financial Stability Fund (EFSF) that expires in mid-2013.

Collective action clauses will be included in sovereign issues that will allow a qualified majority to agree to concessions and allow a orderly restructuring of sovereign debt with bond holders participating.  At the same time, European officials drew back from the reports that circulated before the weekend that holders of senior (Irish) bank debt would lose part of their guarantees.  One of the implications is subordinated debt holders would likely take a bigger haircut than the 80% seen as recently as last week.    After all, the European officials have not really gotten ahead of the curve of expectations.  The approval of the Irish budget next week is still not a done deal and investors are not convinced the measures will make for a strong firewall around Portugal and, more importantly Spain.  Meanwhile, the political situation in Europe is set to intensify, with the Irish government on the verge of collapsing and over the weekend the unlikely CDU-Green coalition in Hamburg collapsed.  This means that Germany will hold at least seven state elections next year, leaving German domestic politics to have a large influence on the country’s external stance.  Equally important, shortly after the Italian budget is approved (Dec 10), Prime Minister Berlusconi faces a confidence vote that appears likely to lead to a national election early next year.

We continue to point out how well the US-German 2-year note differential has been tracking the euro-dollar exchange rate.  The recent peak in Germany’s favor took place on Oct 28 near 67 bp.  The euro peaked a few days later on Nov 4.  The spread today is quoted just below 39 bp, the smallest German premium since Oct 6.   In addition, we have been closely monitoring the premium the market pays for euro puts over euro calls.  It gave us an early warning of that the euro longs were getting nervous.  The measure bottomed (euro puts over calls) on October 18 and has collapsed.  The market is now paying the largest premium for euro puts since late June/early July.  The euro’s loss today are pushing it through the trend line drawn off the June and Aug lows (~$1.3210 today) and is convincingly falling below the 100-day moving average since early August.  The next important chart points are seen in the $1.3080-$1.3130 area, which corresponds with a 50% retracement of the euro’s rally from the $1.1877 multi-year low set in early June and the 200-day moving average.
Upcoming Economic Releases

At 10:30 EST / 14:30 GMT US reports the Dallas Fed Manufacturing Activity Index.  The index does not have a survey but last month’s 2.6 figure is much higher than the quarterly moving average of -6.6.  At the same time Canada reports industrial production and the current account.  The former is expected to remain unchanged while the latter is expected to widen to –C$15.2bln from –C$11bln.  Hungary announces base rate which is expected to remain unchanged at 5.25%.  Events: Fed’s Bullard (FOMC voter) at 1:30 PM / 17:30 GMT.