Eurozone quest to 'Greece'-proof paper!

Trading volumes were very light yesterday and while there have been no developments in the eurozone’s quest to solve the issues of fiscal integration or mutual liability (‘Greece’-proofing their paper) or any let up in the decline in Spanish and Italian bond prices, the EUR traded fairly resiliently. This buoyancy is, in part, a result of a market that has already positioned itself substantially short of EUR yet is also a function of the increasing potential of the US to debase the USD further through more QE. The release of retail sales yesterday was weak enough (including back revisions) to suggest a downward revision to expectations for Q2 US GDP. Whilst my view is that the current pedestrian growth rate does not create the urgency for the Fed to justify further money printing (in the face of increasing political opposition) at this juncture, at the margin it proved enough to squeeze out some of the weak shorts.

Almost junk?

Overnight rating agency Moody’s brought the eurozone and Spain back to the forefront of considerations as they cut the Spanish Sovereign 3 notches to Baa3, just a single notch above junk status. In itself, amid the current turmoil, this is perhaps not a surprise but the detail of the rationale is the key point. Moody’s indicated that the bailout package for Spanish banks was perhaps a concern and not a relief, as PM Rajoy and a host of eurozone officials would have lead us to believe. They stated that the bank bailout “…will further increase the country’s debt burden, which has risen dramatically since the onset of the financial crisis”.

A vicious circle?

In conjunction with the market reaction to the ‘bailout’ which has meant that Spain has been effectively shut out of the market and hence almost by default, the Spanish bank bailout may well precipitate the need for a further bailout!  

I have mentioned in previous blogs that the German position on the eurozone periphery may eventually be outweighed by the increasing exposure of German banks to their more embattled counterparts through the Target2 system. At the end of May, new figures suggest that the German exposure to the Target2 stood at EUR 698.6 billion. The Greek elections at the weekend could potentially make this consideration more acute.

The Greek elections this weekend have already inspired some position squaring this week, in an otherwise quiet trading dynamic. My central expectation is still that the New Democracy party will achieve the highest number of seats and that they will fairly quickly agree to form a centrist coalition, and avoid the threat to the eurozone of the far left Syriza in office. This is however my central view in a very uncertain environment and a number of alternative, perhaps less market friendly outcomes have a significant probability.

Safety net?

Angela Merkel has stated that she will be on a plane on her way to Mexico for the G20 summit when the Greek election results are announced, but despite this I would anticipate that the G20 will be capable of producing a number of stabilisation measures, should a disorderly reaction to the election outcome occur.

For the day, markets will continue to be driven by sentiment and positioning. Spanish 10 year yields are gravitating towards the psychologically (and perhaps self fulfillingly) destructive 7% level. A break above this level may inspire further EUR selling. However, this afternoon’s US inflation data release will likely keep up the increasingly disinflationary theme that is spreading across the slowing global economy and an outcome lower than the expected 1.8% could well see the USD come under some pressure as the US QE3 advocates become increasingly audible. The markets are likely to become increasingly volatile into the weekend.

Aside from the obvious troubles in the eurozone, there are an increasing number of concerning eurozone data releases, particularly consumer spending data. Dutch retail sales for April plunged 8.7% on an annual basis, and this is before the negative impact on national team football shirts that last night's Euro2012 performance may have inspired!