Weekly Spotlight: Europe’s Outlook Progressively Worsens
Posted 06-16-2010 at 09:20 AM by DailyFX
European woes continue to remain in the spotlight, and it is unlikely that the lens will change focus in the near term as ballooning budget deficits in the 16-member euro area continue to rattle the markets. Indeed, Europe’s outlook seems to progressively worsen week by week, and we may see the bloc slip back into recession by the end of this year.
Talking Points
• Euro Defines “the Unholy Trinity”
• Concerns increase of Double-Dip Euro-zone Recession
• Why a Euro Breakup Will Lead to Chaos
Taking a look at recent developments, on Friday, May 28th, Fitch downgraded Spain’s long term foreign and local currency issue default ratings from “AAA” to “AA+,” while Hungary’s Prime Minister on June 8th raised the possibility that the country might default because the previous administration “manipulated” figures. As of late, Moody’s became the third rating agency to downgrade Greece’s government bonds. Greek notes were slashed into junk territory, deepening worries about Europe’s debt crisis. With the credibility of Greece on the line, there are not too many solutions for the ailing economy.
First and foremost, the EU-IMF life line worth nearly $1 trillion will give Greece time to cut its fiscal deficit, one being, scaling back its stimulus measures. If indeed fiscal measures remain controllable amid domestic resistance, the recent jump in bonds may calm fears that the Greek government is not credible. On the other hand, a debt restructuring plan/debt swap could be proposed, similar to the Brady Bond plan. The program was effective in Latin America during the 1980’s where toxic assets were transformed into marketable debt through the use of another financial instrument. In this case, Greece will remain a part of the euro-zone and negotiate with its bondholders. All in all, we can expect the euro bloc to do everything in its power to avoid one or more countries from exiting the euro in order to avoid further negative spillover effects. However, as the bloc remains intact, market participants fear that the Euro-zone will slip back into recession by the end of the year.
Concerns of Double-Dip Euro-zone Recession
As of late, I noted that concerns of a downturn for the 16-member euro area were increasing as it comes to light that governments will have to phase out stimulus measures amid ballooning budget deficits that they are faced with. Adding onto my specualtion, Fitch Ratings recently said that they see “increasing concern that there will be a double-dip recession in the euro-zone”, and went onto say that “it’s becoming an increasingly plausible alternative.” This alternative may become a reality as the lifeline package is surely not enough for the indebted countries.
Why a Euro Breakup will lead to Chaos
If one or more countries leave the euro, the likely result will be an abundance of lawsuits. Preston Keat, research director of consulting firm Eurasia Group notes that local companies with contracts linked to the euro will be thrown in turmoil, and “all contracts- including those governing wages, bank deposits, bonds, mortgages, taxes, and almost everything else” will have to be redenominated in the new currency. “In short, this would violate all kinds of laws and treaties and rules at the national, EU, and internal levels,” he later adds. I concur with Keat, however, it is noteworthy that a default will also destabilize the euro zone and trigger a recession, with the after effects of global contagion. Thus, the talk of Greece or any other country leaving the euro is highly unlikely.
Euro Defines “the Unholy Trinity”
In academia, some economists would say that the single currency is a pure example of the Mundell-Fleming “trilemma,” in which the model is used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. However, the model does not take into consideration default, inflation, or future price levels. Whether this model is right, one thing for sure is that fiscal contraction in the 16-member euro area will cause deflation over time, and an exchange rate is expected to return to some sort of purchasing power parity in the long run. Thus, the expected deprecation means a nominal and real depreciation in the single currency within the short term.
What can we expect going forward?
Looking ahead, the ECB is said to take a 5 percent haircut on all Greek bonds which are posted as collateral with the central bank, leading Greece to post additional bonds in order to cover the spread. At the same time, an EU draft report warned that there is a need for more deficit cuts in both Portugal and Spain by next year. Moreover, the report said the “snowball” effect will impact Spanish and Portuguese debt, and a similar report is likely to be released about Italy as the country is heavily indebted as well. All in all, though there is a much needed correction for the EUR/USD, we may see price action push lower in the medium term.
The yield on Greek 10 year notes are up 96 basis points in the past 5 days, and have rallied 386 basis points to 9.07% in the past year, making Greece’s borrowing costs more expensive. Additionally, Italy’s, Portugal’s and Spain’s 10 year bonds have come under pressure this week, with the countries yield climbing 39, 22, and 14 basis points respectively.
Credit default swaps on 10 year government bonds for “PIGS” have pushed slightly lower from last week. Indeed, insurance against highly indebted countries in Western Europe is gaining momentum as market participants bet that Greece and its neighbors are heading towards default. Furthermore, Italy’s and Greece’s debt to GDP of approximately 115% in 2009 are additional concerns for investors as their bad debt will now have to be restructured. Comparatively to the U.S. where bad debt is in the private sector, for the Europeans, bad debt is in the public sector, and the nearly $1 trillion life line calls for passing on this debt onto the taxpayers of solvent states. One of the main problems with Europe is that peripheral states cannot keep up with the interest on the money that they borrow.
The 21-day correlation between the EURUSD and the MSCI World Stock Index now stands at 0.0.39, down from 0.67 last week. This is a signal that the EU crisis driving risk aversion is tapering off.
The euro looks to continue its southern descent against the U.S. dollar that began earlier this year amid the media frenzy surrounding the brewing sovereign debt crisis in Europe. From a technical standpoint, the pair has broken below an eight year rising trend which I noted earlier this month when the pair was trading at 1.32. As of today, the EUR/USD exchange rate stands at 1.23, and it looks apparent that the pair will rebound on the back of a much needed correction before pushing lower. it is noteworthy that a break below 1.18 exposes support at 1.15. Additionally, the Purchasing Power Parity now stands at 7.97%, down from its extreme level of 24.35% in the November, a signal that the euro may bottom out in the near term versus the U.S. dollar. It is also worth mentioning that the daily studies look to have stabilized from oversold levels.
Weekly Glossary
Credit Default Swap
A credit default swap (CDS) is a type of insurance that allows an investor to buy insurance against a bond issued by a country or a company. In detail, the buyer makes standard premium payments until the end of the contract as long as the borrower does not default. However, if the borrower defaults, the CDS holder is paid by the seller of the protection and the buyer then ceases to pay the payments. Market participants may use Credit Default Swaps for speculative purposes, betting against the solvency of the borrower, and in return receiving capital if it defaults. On the other hand, traders may use CDS contracts to hedge their investments.
MSCI World Stock Index
The MSCI Index is the collective of global companies which includes small, micro, mid, and large size companies.
Purchasing Power Parity (PPP)
One of the oldest and most basic fundamental approaches to determine the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. We compare values in PP to determine how much each currency is under – or over-valued against the U.S. dollar.
Chicago Board Options Exchange Volatility Index (VIX)
The symbol for the Chicago Board Options Exchange Volatility index, the VIX is one of the most used measures of implied volatility of the S&P 500 index options. The objective of the VIX is to estimate the implied volatility of the S&P 500 over the next 30 days, on an annualized basis. Investors may use the index in tandem with recent fundamental developments in order speculate reverses or continuation of upward/downward trend.
Talking Points
• Euro Defines “the Unholy Trinity”
• Concerns increase of Double-Dip Euro-zone Recession
• Why a Euro Breakup Will Lead to Chaos
Taking a look at recent developments, on Friday, May 28th, Fitch downgraded Spain’s long term foreign and local currency issue default ratings from “AAA” to “AA+,” while Hungary’s Prime Minister on June 8th raised the possibility that the country might default because the previous administration “manipulated” figures. As of late, Moody’s became the third rating agency to downgrade Greece’s government bonds. Greek notes were slashed into junk territory, deepening worries about Europe’s debt crisis. With the credibility of Greece on the line, there are not too many solutions for the ailing economy.
First and foremost, the EU-IMF life line worth nearly $1 trillion will give Greece time to cut its fiscal deficit, one being, scaling back its stimulus measures. If indeed fiscal measures remain controllable amid domestic resistance, the recent jump in bonds may calm fears that the Greek government is not credible. On the other hand, a debt restructuring plan/debt swap could be proposed, similar to the Brady Bond plan. The program was effective in Latin America during the 1980’s where toxic assets were transformed into marketable debt through the use of another financial instrument. In this case, Greece will remain a part of the euro-zone and negotiate with its bondholders. All in all, we can expect the euro bloc to do everything in its power to avoid one or more countries from exiting the euro in order to avoid further negative spillover effects. However, as the bloc remains intact, market participants fear that the Euro-zone will slip back into recession by the end of the year.
Concerns of Double-Dip Euro-zone Recession
As of late, I noted that concerns of a downturn for the 16-member euro area were increasing as it comes to light that governments will have to phase out stimulus measures amid ballooning budget deficits that they are faced with. Adding onto my specualtion, Fitch Ratings recently said that they see “increasing concern that there will be a double-dip recession in the euro-zone”, and went onto say that “it’s becoming an increasingly plausible alternative.” This alternative may become a reality as the lifeline package is surely not enough for the indebted countries.
Why a Euro Breakup will lead to Chaos
If one or more countries leave the euro, the likely result will be an abundance of lawsuits. Preston Keat, research director of consulting firm Eurasia Group notes that local companies with contracts linked to the euro will be thrown in turmoil, and “all contracts- including those governing wages, bank deposits, bonds, mortgages, taxes, and almost everything else” will have to be redenominated in the new currency. “In short, this would violate all kinds of laws and treaties and rules at the national, EU, and internal levels,” he later adds. I concur with Keat, however, it is noteworthy that a default will also destabilize the euro zone and trigger a recession, with the after effects of global contagion. Thus, the talk of Greece or any other country leaving the euro is highly unlikely.
Euro Defines “the Unholy Trinity”
In academia, some economists would say that the single currency is a pure example of the Mundell-Fleming “trilemma,” in which the model is used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. However, the model does not take into consideration default, inflation, or future price levels. Whether this model is right, one thing for sure is that fiscal contraction in the 16-member euro area will cause deflation over time, and an exchange rate is expected to return to some sort of purchasing power parity in the long run. Thus, the expected deprecation means a nominal and real depreciation in the single currency within the short term.
What can we expect going forward?
Looking ahead, the ECB is said to take a 5 percent haircut on all Greek bonds which are posted as collateral with the central bank, leading Greece to post additional bonds in order to cover the spread. At the same time, an EU draft report warned that there is a need for more deficit cuts in both Portugal and Spain by next year. Moreover, the report said the “snowball” effect will impact Spanish and Portuguese debt, and a similar report is likely to be released about Italy as the country is heavily indebted as well. All in all, though there is a much needed correction for the EUR/USD, we may see price action push lower in the medium term.
The yield on Greek 10 year notes are up 96 basis points in the past 5 days, and have rallied 386 basis points to 9.07% in the past year, making Greece’s borrowing costs more expensive. Additionally, Italy’s, Portugal’s and Spain’s 10 year bonds have come under pressure this week, with the countries yield climbing 39, 22, and 14 basis points respectively.
Credit default swaps on 10 year government bonds for “PIGS” have pushed slightly lower from last week. Indeed, insurance against highly indebted countries in Western Europe is gaining momentum as market participants bet that Greece and its neighbors are heading towards default. Furthermore, Italy’s and Greece’s debt to GDP of approximately 115% in 2009 are additional concerns for investors as their bad debt will now have to be restructured. Comparatively to the U.S. where bad debt is in the private sector, for the Europeans, bad debt is in the public sector, and the nearly $1 trillion life line calls for passing on this debt onto the taxpayers of solvent states. One of the main problems with Europe is that peripheral states cannot keep up with the interest on the money that they borrow.
The 21-day correlation between the EURUSD and the MSCI World Stock Index now stands at 0.0.39, down from 0.67 last week. This is a signal that the EU crisis driving risk aversion is tapering off.
The euro looks to continue its southern descent against the U.S. dollar that began earlier this year amid the media frenzy surrounding the brewing sovereign debt crisis in Europe. From a technical standpoint, the pair has broken below an eight year rising trend which I noted earlier this month when the pair was trading at 1.32. As of today, the EUR/USD exchange rate stands at 1.23, and it looks apparent that the pair will rebound on the back of a much needed correction before pushing lower. it is noteworthy that a break below 1.18 exposes support at 1.15. Additionally, the Purchasing Power Parity now stands at 7.97%, down from its extreme level of 24.35% in the November, a signal that the euro may bottom out in the near term versus the U.S. dollar. It is also worth mentioning that the daily studies look to have stabilized from oversold levels.
Weekly Glossary
Credit Default Swap
A credit default swap (CDS) is a type of insurance that allows an investor to buy insurance against a bond issued by a country or a company. In detail, the buyer makes standard premium payments until the end of the contract as long as the borrower does not default. However, if the borrower defaults, the CDS holder is paid by the seller of the protection and the buyer then ceases to pay the payments. Market participants may use Credit Default Swaps for speculative purposes, betting against the solvency of the borrower, and in return receiving capital if it defaults. On the other hand, traders may use CDS contracts to hedge their investments.
MSCI World Stock Index
The MSCI Index is the collective of global companies which includes small, micro, mid, and large size companies.
Purchasing Power Parity (PPP)
One of the oldest and most basic fundamental approaches to determine the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. We compare values in PP to determine how much each currency is under – or over-valued against the U.S. dollar.
Chicago Board Options Exchange Volatility Index (VIX)
The symbol for the Chicago Board Options Exchange Volatility index, the VIX is one of the most used measures of implied volatility of the S&P 500 index options. The objective of the VIX is to estimate the implied volatility of the S&P 500 over the next 30 days, on an annualized basis. Investors may use the index in tandem with recent fundamental developments in order speculate reverses or continuation of upward/downward trend.
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