Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

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The Italian Job

Italy looks too big to rescue yet is too big to fail. The country has around EUR 1.9 trillion in public debt (around 5 times that of Greece) and is the third largest country in the eurozone. Therefore it cannot be as easily dealt with as Greece.

Italy needs to raise around EUR 18 billion per month to cover its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable. Higher collateral haircuts on Italian debt are adding to the pressure.

Although Italian Prime Minister Berlusconi has said he will step down in the wake of reform measures to be voted on by the Italian parliament the vote on the measures may not take place for weeks. Moreover, Berlusconi may attempt to seek re-election after stepping down, which could bring the situation back to square one.

In the meantime speculation that Italy may be the next country to need to a bailout will intensify. However, with only around EUR 270 billion remaining in the EFSF bailout fund and details of how the fund will be leveraged to a planned EUR 1 trillion still lacking, doubts about whether it will have sufficient resources will grow. Press reports that Germany and France have begun talks to break up the eurozone due to fears that Italy will be too big to rescue will only add to the malaise.

Focus over the short term will turn to today’s 12 month auction of EUR 5 billion in Italy. Last month’s 12 month auction saw an average yield of 3.57% but this time around yields could rise above 6%. Worryingly it appears that even with the European Central Bank (ECB) buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s reluctance to become lender of the last resort to European peripherals, any support from this direction will be limited. Against this background the EUR remains highly vulnerable to a further drop. Indeed, the EUR’s recent resilience looks all the more misplaced. A test of the 4 October low around EUR/USD 1.3146 is on the cards over coming days.

Drastic Action Needed

There has been no let up in pressure on eurozone markets and consequently risk aversion continues to increase. The failure of Ireland’s bailout package to stem the haemorrhaging in eurozone bond markets highlights the difficulties in finding in a lasting solution and worsening liquidity conditions in several eurozone bond markets highlights the urgency to act.

Indeed, if spreads continue to widen as they have since late October, by early to mid 2011, Portuguese, Spanish and Italian Euribor spreads would be higher than the EFSF loan spread. In the (admittedly extreme) case that sovereigns could not raise money in the market, peripherals would run out of money early in 2011. Policy makers will try to not let the situation get so out of hand but what can be done to stem the damage?

The European Central Bank (ECB) may be forced to delay its exit strategy by maintaining unlimited liquidity allotments to banks into next year and/or implement further liquidity support measures. The ECB meeting will be closely scrutinized for details, with ECB President Trichet having to adjust policy accordingly. A further option could be for the ECB to step up its bond buying programme which may provide some relief to peripheral eurozone bond markets and the EUR.

Whether this offers a lasting solution however, is debatable. The risk of action by the ECB tomorrow may fuel some caution in the market towards selling the EUR further in the short term and could even prompt some short EUR covering around the meeting which could see EUR/USD regain a sustainable hold above 1.3000 again but this may be temporary, offering better levels to sell.

Meanwhile, speculation of a break up of the eurozone into a core euro and a peripheral euro has intensified given the growing divergence in growth and competitiveness across the region. Such speculation looks far fetched. The eurozone project has been politically driven from the start and over the last 60 years or so internal economic strains have been papered over by politicians. The political will is likely to remain in place even if the divergence in fundamentals across Europe has continued to widen.

Bond market sentiment was not helped by the fact that S&P put Portugal’s ratings on creditwatch negative citing downward economic pressure and concerns over the government’s credit worthiness. Importantly S&P still expects Portugal to remain at investment grade if downgraded. Note that Portugal’s central bank highlighted that the country’s banking sector faced “intolerable” risk unless the government implements planned austerity measures.

In contrast the US story is looking increasingly positive, highlighting that the USD’s strength is not merely a reaction to EUR weakness but more likely inherent and broad improvement in USD sentiment. US consumer confidence, Chicago PMI and the Milwaukee PMI beat forecasts in November, continuing the trend of consensus beating data releases over recent weeks.
Although this does not change the outlook for quantitative easing (QE) as the Fed remains focused on core CPI and the unemployment rate, the data paints an encouraging picture of the economy.

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