Irish bailout leaves EUR unimpressed

As has been the case since the beginning of the global financial crisis policy makers have found themselves under pressure to deliver a solution to a potentially destabilising or even systemic risk before the markets open for a new week in order to prevent wider contagion. Last night was no different and following urgent discussions a EUR 85 billion bailout for Ireland to be drawn down over a period of 7 ½ years was agreed whilst moves towards a permanent crisis mechanism were brought forward. As was evident over a week ago a bailout was inevitable but the terms were the main imponderable.

Importantly the financing rate for the package is lower than feared (speculation centered on a rate of 6.7%) but still relatively high at 5.8%. Moreover, no haircuts are required for holders of senior debt of Irish banks and Germany’s call for bondholders to bear the brunt of losses in future crises was watered down. The package will be composed of EUR 45 bn from European governments, EUR 22.5 bn from the IMF and EUR 17.5 bn from Ireland’s cash reserve and national pension fund.

The impact on the EUR was stark, with the currency swinging in a 120 point range and failing to hold its initial rally following the announcement. A break below the 200-day moving average for EUR/USD around 1.3131 will trigger a drop to around 1.3020 technical support. Officials will hope that the bailout offers the currency some deeper support but this already seems to be wishful thinking. The EUR reaction following the Greek bailout in early May does not offer an encouraging comparison; after an initial rally the EUR lost close to 10% of its value over the following few weeks.

Although it should be noted that the bailout appears more generous than initially expected clearly the lack of follow through in terms of EUR upside will come as a blow. The aid package has bought Ireland some breathing space but this could be short lived if Ireland’s budget on December 7 is not passed. Moreover, the bailout will not quell expectations that Portugal and perhaps even Spain will require assistance. Indeed, Portugal is the next focus and the reaction to an auction of 12-month bills on 1 December will be of particular interest.

Taken together with continued tensions on the Korean peninsular, position closing towards year end ongoing Eurozone concerns will likely see a further withdrawal from risk trades over coming weeks. For Asian currencies this spells more weakness and similarly commodity currencies such as AUD and NZD also are likely to face more pressure. The USD remains a net beneficiary even as the Fed continues to print more USDs in the form of QE2.

Data and events this week have the potential to change the markets perspective, especially the US November jobs report at the end of the week. There is no doubt that payrolls are on an improving trend (145k consensus) in line with the declining trend in jobless claims but unfortunately the unemployment rate is set to remain stubbornly high at 9.6% and this will be the bigger focus for the Fed and markets as it implies not let up in QE. As usual further clues to the payrolls will be garnered from the ADP jobs report and ISM data on Wednesday.


Edging Towards A Bailout

A confluence of factors have come together to sour market sentiment although there appeared to be some relief, with a soft US inflation reading (core CPI now at 0.6% YoY) and plunge in US October housing starts reinforcing the view that the Fed will remain committed to carry out its full QE2 program, if not more.

However any market relief looks tenuous. Commodity prices remain weak, with the CRB commodities index down 7.4% in just over a week whilst the Baltic Dry Index (a pretty good forward indicator of activity and sentiment) continues to drop, down around 21% since its recent high on 27 October. Moreover, oil prices are also sharply lower. Increasingly the drop in risk assets is taking on the form of a rout and many who were looking for the rally to be sustained into year end are getting their fingers burnt.

Worries about eurozone peripheral countries debt problems remains the main cause of market angst, with plenty of attention on whether Ireland accepts a bailout rumoured to be up EUR 100 billion. Unfortunately Ireland’s reluctance to accept assistance has turned into a wider problem across the eurozone with debt in Portugal, Greece and also Spain suffering. An Irish bailout increasingly has the sense of inevitability about it. When it happens it may offer some short term relief to eurozone markets but Ireland will hardly be inspired by the fact that Greece’s bailout has had little sustainable impact on its debt markets.

Ireland remains the primary focus with discussions being enlarged to include the IMF a well as ECB and EU. What appears to be becoming clearer is that any agreement is likely to involve some form of bank restructuring, with the IMF likely to go over bank’s books during its visit. Irish banks have increasingly relied on ECB funding and a bailout would help reduce this reliance. Notably the UK which didn’t contribute to Greece’s aid package has said that it will back support for Ireland, a likely reaction to potential spillover to UK banks should the Irish situation spiral out of control. Any bailout will likely arrive quite quickly once agreed.

Although accepting a bailout may give Ireland some breathing room its and other peripheral county problems will be far from over. Uncertainties about the cost of recapitalising Ireland’s bank will remain whilst there remains no guarantee that the country’s budget on December 7 (or earlier if speculation proves correct) will be passed. Should Ireland agree to a bailout if may provide the EUR will some temporary relief but FX markets are likely to battle between attention on Fed QE2 and renewed concerns about the eurozone periphery, suggesting some volatile price action in the days and weeks ahead.

Reports of food price controls of and other measures to limit hot money inflows into China as well as prospects for further Chinese monetary tightening, are attacking sentiment from another angle. China’s markets have been hit hard over against the background of such worries, with the Shanghai Composite down around 10% over the past week whilst the impact is also being felt in many China sensitive markets across Asia as well as Australia. For instance the Hang Seng index is down around 7% since its 8 November high.

Caught In The Headlights

For a prolonged period of time market attention had firmly focused on the Fed and prospects for quantitative easing (QE2). Now that QE has been delivered with little surprise, as the Federal Reserve arguably did a good job of living up to market expectations, it is Europe that is back in the limelight. Until recently the major surprise about Europe was how well the economy and the EUR were doing and how quickly the European Central Bank (ECB) would diverge from the Fed in its policy path.

This all looks premature and as if to confirm the shift in outlook the slowing in eurozone growth in Q4 (0.4% QoQ) revealed last week is likely to mark the beginning of a sharp and diverging deceleration in growth over coming quarters. The EUR may still have some life left in it given the ongoing purchases via recycled intervention flows from Asian central banks but weaker growth and peripheral worries are undermining this vestige of support.

Unfortunately for Europe the region is now not being caste in a good light and the peripheral trio of Ireland, Greece and Portugal are all staring into the headlights with nowhere to run. A crash of sorts seems inevitable but will there be any casualties? Markets are being whipsawed as they determine what will happen next in this slow motion saga.

Irish officials have maintained they do not need any aid package following discussions held over the weekend. Any bailout would likely come from a EUR 60 billion fund from the European Commission meaning a quick distribution but Ireland’s refusal will likely see pressure resume on peripheral debt markets in Europe as well as the EUR.

Portugal is also in the spotlight following comments by its foreign minister that the country may be forced to abandon the EUR if there is a failure to adopt a broad coalition government to deal with the crisis. This sounds like scaremongering but nonetheless highlights the political tensions in the country.

In Greece the second round of regional elections reveals the ruling Pasok party candidates are in the lead, reducing the prospect of early general elections. Nonetheless, this will do little to alleviate pressure as the EU is set to revise higher Greece’s 2009 deficit and debt estimates implying even more difficulty in meeting this year’s targets.

An EU/IMF team will visit Greece to assess progress as well as decide on whether the country should receive its 3rd instalment of a EUR 110 billion loan. Suggestions from PM Papandreou that he does not rule out having to extend the repayment of the loan will not auger well for sentiment. Finally, the government is set to present its 2011 final budget on Thursday, suggesting plenty of event risk this week.

A meeting of EU finance ministers tomorrow and Wednesday will also garner attention. Germany’s stance that investors will only have to take the brunt of losses from debt rescheduling only from 2013 still remains a contentious issue amongst officials even though it is a slightly softer stance than previously stated. Agreement on this as well as pressure on Ireland to accept funding will be key points of discussion.

Event wise, an auction of T-bills in Greece tomorrow as well as a Spanish debt auction on Thursday will be watched to determine how far the contagion of Irish woes have spread. The news is unlikely to be good, with higher yields likely. Unfortunately tomorrow’s German November ZEW investor confidence survey will provide further signs of retreating investor sentiment in the wake of renewed peripheral debt concerns.

Euro pressure mounts

The effects of eurozone peripheral bond concerns are cascading through eurozone markets and hitting risk appetite in the process. The EUR is a clear casualty having dropped further against the USD and versus other currencies. EUR/Asian FX remains a sell in the current environment. Contagion outside Greece, Portugal and Ireland had been limited but Italy and Spain have also seen a growing impact on their bond markets. Having broke below support around 1.3734, EUR/USD will target 1.3508 support.

Speculation that Ireland will be forced to follow Greece in seeking international financial support has intensified. Although Ireland has sufficient funds to last until next spring, yields on its debt are already higher than Greek debt before it received funds a few months back. Attention is firmly fixed on the country’s budget on 7 December and the prospects of an agreement between the government and opposition in its austerity plans.

Not helping is the fact that the Irish government has a very slim majority. Even if the budget is passed there is no guarantee that sentiment will improve given the negative impact of even deeper fiscal tightening announced last week will have on economic growth. Moreover, Germany’s insistence that the cost of any Greek style bailout should be borne mostly by private investors has only added to market tension. Even the European Central Bank is unlikely to provide much support, with ECB member Stark suggesting that ECB bond purchases will remain limited.

This leaves eurozone markets in a precarious state and the EUR continues to look heavy as further downside opens up. Moreover, the problems in peripheral Europe are beginning to have a broader impact on risk appetite, with equity markets slipping, although some of this was related to a weaker sales forecast from Cisco in the US. Nonetheless, spreading risk aversion could also dampen sentiment for Asian currencies, which is why selling EUR/Asian FX looks a better bet than selling USD/Asian FX over the short term.

In contrast sentiment for the US is undergoing an improvement. Data releases over recent weeks have generally beaten forecasts and there is even growing speculation that the Fed’s calibrated asset purchases may end up being smaller than planned. Such speculation has boosted the USD but it is premature to suggest that the Fed is on the verge of scaling back asset purchases even as the program of purchases gets going. Although there are clearly some FOMC members who are opposed to significant asset purchases the probability that the Fed remains set to carry out its full $600 billion of planned purchases.

Attention today will focus squarely on day 2 of the G20 meeting and any resolution to disputes over trade imbalances and currencies. Unfortunately none is likely to be forthcoming. Despite a reported 80 minute meeting between US and Chinese leaders little agreement was reached, with plenty of finger pointing remaining in place. It appears that the mantra of moving towards “market-determined exchange rates” and efforts at “reducing excessive imbalances” as agreed at the G20 meeting of finance ministers and central bankers will be as far as any agreement reaches. As a result markets will be left with very little to chew on.

Peripheral debt concerns intensify

European peripheral debt concerns have allowed the USD a semblance of support as the EUR/USD pullback appears to have gathered momentum following its post FOMC meeting peak of around 1.4282. The blow out in peripheral bond spreads has intensified, with Greek, Portuguese and Irish 10 year debt spreads against bonds widening by around 290bps, 136bps and 200bps, respectively from around mid October.

The EUR appears to have taken over from the USD, at least for now, as the weakest link in terms of currencies. EUR/USD looks vulnerable to a break below technical support around 1.3732. Aside from peripheral debt concerns US bonds yields have increased over recent days, with the spread between 10-year US and German bonds widening by around 17 basis points in favour of the USD since the beginning of the month.

The correlation between the bond spread and EUR/USD is significant at around 0.76 over the past 3-months, highlighting the importance of yield spreads in the recent move in the USD against some currencies. Similarly high correlations exist for AUD/USD, USD/JPY and USD/CHF.

Data today will offer little direction for markets suggesting that the risk off mood may continue. US data includes the September trade deficit. The data will be scrutinized for the balance with China, especially following the ongoing widening in the bilateral deficit over recent months, hitting a new record of $28 billion in August. Similarly an expected increase in China’s trade surplus will add to the currency tensions between the two countries. FX tensions will be highlighted at the Seoul G20 meeting beginning tomorrow, with criticism of US QE2 gathering steam.

Commodity and Asian currencies are looking somewhat precariously perched in the near term, with AUD/USD verging on a renewed decline through parity despite robust September home loan approvals data released this morning, which revealed a 1.3% gain, the third straight monthly increase.

However, the NZD looks even more vulnerable following comments by RBNZ governor Bollard that the strength of the Kiwi may reduce the need for higher interest rates. As a result, AUD/NZD has spiked and could see a renewed break above 1.3000 today. Asian currencies are also likely to remain on the backfoot today due both to a firmer USD in general but also nervousness ahead of the G20 meeting.

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