Europe's Crisis Deepens

Currency in Crisis
There is one major driver in capital markets and it is the the widening crisis in Europe. Month end demand for euros has been more than offset by concern that Europe is experiencing a systemic and existential challenge. Pressure is evident outside of the periphery, which has up until now been the main focus. Spanish, Italian and Belgian bonds are getting hit harder than Portugal and Greek bonds in recent sessions.

Over the past five days, the 10-year Italian bond yield is up 40 bp. The similar yield in Spain is up 56 bp and up 38 bp in Belgium. The 10-year yields in Portugal are flat and off 23 bp in Greece. The ECB did step up its sovereign bond purchases last week to the most in 2-months. But the contagion risk is palpable. The Irish package failed to dispel misgivings. The fact that Ireland itself coming up with 20% of its own aid package seems to deny officials any shock and awe potential. Moreover, the interest rate average of 5.8% does not appear very concessionary, though it is lower than the crisis induced levels. In addition, officials have failed to get ahead of the curve of market expectations in preemptive funding of Portugal, if not Spain (where the old saw of a stitch in time saves nine comes to mind).

Perhaps the biggest problem is lack of appreciation of the significance of confidence in the functioning of the modern credit economy. European officials have squandered this confidence and like toothpaste coming out of a tube, it is difficult to put in back in. Spain, for example, we are told, is not a problem because the government debt to GDP is a relative mild 63% of GDP. Yet the total debt is closer to 270% of GDP. While the IMF estimates the gross financing needs for 2011 will be 226 bln euros (~21% of GDP), Spanish banks appear to have to roll over the same amount.

What is the ECB to do? It meets on Thursday, December 2. It had been expected to announce plans to continue to unwind its extraordinary liquidity provisions in the new year. If it were to follow through with this, it could exacerbate the current crisis. However, this is to simply move to the other horn of the policy dilemma. Its unlimited provision of liquidity for three-months at 1% may be supporting insolvent institutions and keeps the paper chase going without addressing it.

I had thought there was some risk of a euro bounce here today. The half-hearted attempt in Asia ran out of steam near $1.3150. On the downside, mostly seen in the European morning, saw the euro take out not only the $1.30 level (low near $1.2980), but also the JPY109.50, CHF1.30, and GBP0.8400.

Euro resistance is now seen near $1.3050-60. Sentiment is as extreme as it has been since the heart of the crisis earlier this (May and June). The net speculative position at the IMM has swung to short euros for the first time in a couple of months. The indicators I have used to help anticipate the euro slide continue to point to additional losses. The 2-year US-German interest rate spread is drifting in the US direction still ( a 21 bp swing in the past seven sessions) and the premium the market is paying for euro puts over calls (3-month) continues to grow. It is now near 2.5% compared with less than 1% in late October. The premium began growing before the euro peaked. Same thing, more or less took place at the end of last year as well.
Europe's Crisis Deepens Europe's Crisis Deepens Reviewed by Marc Chandler on November 30, 2010 Rating: 5
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