Euro Stages A Recovery As Peripheral Sentiment Improves, Spain Debt Auction Goes Well
- The US dollar is mostly weaker as peripheral sentiment improve
- Spanish bond auction went well, and market expects IMF/EU approval of new Greek package
- With equity markets largely down today, FX decouples from the slowdown theme for now
The dollar is mostly weaker as markets shrug off Moody’s downgrade of Greece yesterday and Spain sees strong demand for its bonds. Trading remains very choppy and dominated by reactions to official headlines and pronouncements. After ending yesterday on a weak note, the euro has bounced back today to post a new high for this move near 1.45 and appears poised to continue gaining as markets seem comfortable with Greece developments. Next retracement level of the euro’s May swoon comes in around 1.4570, break of which targets the May 4 high of 1.4940. Euro was helped by a solid auction in Spain, which sold EUR4 bln in bonds, the maximum target set by the Treasury. Yields on the 3-year bonds were 4.037% vs. 3.568% the last auction, but the bid to cover ratio was 2.49 vs. 1.79 last month. Bid to cover on the longer-dated 4-year bonds was strong too at 2.9. Periphery yields are mixed today, as 10-year Greece up 10 bp, Portugal up 12 bp, Ireland up 4 bp, Spain down 4 bp, and Italy down 4 bp. Equity markets are mostly lower today, though US futures are pointing to a modest up open currently.
This morning, ECB President Trichet called for the creation of a euro zone Finance Ministry. Like us, the ECB has probably gotten tired of the cacophony of voices making pronouncements about the debt crisis, and seems to favor a single overriding voice for the narrative. This is nice in theory, but with fiscal union still years away, we would think that the operational benefits of creating a single ministry would be illusionary. That is not to say it won’t happen. As we have written many times before, this current crisis is forcing the euro zone policy-makers to adapt and evolve. We remain hopeful that fiscal union will eventually be attained, but we think that Trichet’s call is partially a “wish” for euro zone Finance Ministers and officials to speak with one voice and one voice only. If that is the initial goal of creating such a ministry, so be it.
Markets have shrugged off the Greek downgrade, and rightly so. It is a foregone conclusion to most observers that Greece will have to undertake a massive debt restructuring with significant haircuts. The only question is when. Moody’s noted that its Caa1 rating on Greece reflects a 50% chance that Greece defaults over the next 5 years, to which we would counter that we perceive a 100% chance that it does a hard restructuring over the next 2-3 years. The “troika” wraps up its meetings with Greece soon and is now widely expected to announce further funding of Greece in return for more austerity and privatizations. All of the measures being discussed now in the euro zone (Vienna Initiative, more IMF/EU money in return for more pledges of Greek austerity) do not address the fundamental insolvency of Greece. We think policy-makers know this, and are simply trying to delay the disruptions of restructuring until the euro zone banking sector is less vulnerable to such an act. As long as the crisis is contained to Greece, Ireland, and Portugal, our base case is that this strategy is viable. But if Spain or Italy are drawn in, then all bets are off. In that regard, markets should be relieved that the Spanish bond auction went off without a hitch today.
FX markets today seem to be decoupling from the theme that the global economy is losing momentum. Equities are largely lower today, and yet the dollar is back to trading softer across the board, and so there seems to be a disconnect from yesterday’s major theme. There is no telling how long this disconnect will hold given the sharp turns in sentiment seen in recent weeks. EM currencies are largely firmer today, which also seems to be putting global growth concerns on the back burner. We feel that EM economies can still do OK with US growth slowing, as long as a double dip in the US is avoided. That seems to be what the FX market is telling is, with EM currencies mostly trading back toward the year’s highs vs. the dollar after trading softer in May. As long as euro zone muddles through and kicks the can down the road again successfully with regards to the debt crisis, we think that EM FX will continue the rally, albeit at a modest pace. EM officials continue to remain concerned about currency strength for the most part, and so will continue acting to slow the pace. EMEA currencies, which were hit hard in May from the concerns about the euro zone, have bounced back nicely and are likely to outperform near-term. From a more medium-term perspective, however, we favor Latin America and Asia for their superior growth profiles and monetary policy trajectories.