There is no doubt that countries in Europe are going to have to be proactive in order to stop the financial situation from spiraling out of control. Last week we saw major fluctuations in the value of the Euro. At the beginning of the week, we saw an unexpected raise, but the uncertainly of Spain’s financial future caused it to tank by mid-week. As of Monday, experts are expected another drop, but this time it’s Italy that’s causing the fret.
Throughout this crisis Europe’s periphery has been personified as a pack of domino’s – if one falls then others will follow. This time a year ago Spain wasn’t even considered a “peripheral” nation, having the fourth largest economy in the currency bloc. Unfortunately that economy was propped up by an unsustainable property bubble that burst in 2008 leading directly to last weekend’s EU 100bn bailout for its troubled banking sector.
So now the attention turns to the next domino, and unfortunately for the EU authorities, far from ease up pressure on Italian bond yields, Spain’s bailout may have made Italian debt less attractive. There are two reasons why investors may choose not to buy Italian debt: 1, the sovereign debt crisis has been caused by either property crashes (Ireland and Spain) or unsustainable public finances (Greece). In this environment Italy’s 120% debt-to-GDP ratio won’t wash with bond investors, thus it’s hard to see a permanent decline in Italy’s bond yields while debt levels remain so high. 2, Spain’s bailout has opened a debate about the position of private sector bondholders in the pecking order if Spain one day defaults. If Spain gets funds from the ESM then private bond holders are subordinate to European institutions – a real turn off for investors. It is not beyond the realm of possibility that Italy may need a bailout one day, hence investors are immediately suspicious of owning Italian debt, hence its 10-year bond yield jumped to above 6% at one stage today, which is the highest level since January. This is concerning since Italy plans to auction debt on Wednesday and Thursday, which will be a test in confidence towards Mario Monti’s efforts to bring down debt levels in the coming years.
But investors need to know how close the next domino is to falling? Italy’s bond yields might not be in danger territory right now, but there are some worrying signs that investors may turn their attentions to Rome. The spread between Spanish and Italian debt has started to narrow, as Italian bond yields have been rising at a faster pace than Spanish debt. This is definitely a chart I will be watching over the coming days as rising Italian yields could cause another bout of market volatility and bring this crisis to an even more dangerous phase.
Source: Bloomberg and Forex.com
The impact on the euro:
The single currency had a strong move higher versus the dollar post the Spanish bailout, but within a few hours of the European session sentiment towards the euro was flagging. There were a few signs that the bailout to Spanish banks won’t be enough to spur a move towards 1.30 in EURUSD, firstly the sharp spike higher in EURUSD at the Tokyo open was not broad-based, for example EURGBP retreated and so did EURAUD. Secondly, because the euro bulls could not sustain gains above 1.2625 in EURUSD.
Thus, we think that EURUSD could trade with a negative bias as we lead up to the Greek election at the end of this week and the EU summit at the end of June. The details of the bailout for Spain could also erode sentiment especially if it causes tension with Ireland, Portugal and Greece who may try to re-negotiate their bailout terms, adding to investor uncertainty. Today’s close is going to be important, below 1.2580 opens the way to 1.2510- the daily pivot. Next up is 1.2445, a recent low and then 1.2330. 1.2625, the double top from last week, remains a key resistance zone.
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So, the situation in Europe seems to be turning into a full blown crisis. We are now watching the domino effect in action as it knocks down all of the European markets, one by one- which is surprising since one year ago, we hadn’t even considered the possibility that Spain would come unbalanced and cause the European economy to experience such turmoil.
A bailout for Spain may be causing the Italian debt to look a lot more substantial since Spain may be out of the woods- for now. Investors may not want to choose to buy Italian debt now, and here’s why- the sovereign debt crisis has been caused by property crashes or lack of public finances, and the second reason is- Spain’s bailout has stirred new debates about the position of the private sector bondholders if Spain does default.
Investors are rushing to find out which sector is doomed next. The Italian bonds are not yet in danger, but very well could be soon. The gap between the size of Spain’s debt and the size of the Italian debt is getting a lot narrower than initially expected. This is because the Italian bond’s yields are rising at a much faster rate than Spanish debt.
This will certainly have its impact on the already suffering Euro. The Euro held its ground initially against the bailout, but as the details shake out, it is likely to drop off. Another threat to the European currency is the looming political elections in Greece- anti-bailout candidates will likely try to challenge the terms of the bailout if the election puts the people who would do so in office.
Do you see much hope for the future of the European market over the next few months?