Market Unconvinced, Euro Tumbles

The global capital markets are not impressed with the European efforts to stabilize the situation. The euro continues to struggle to sustain even the most modest of upticks and the relief in the European sovereign bond market is hardly convincing. The 85 bln euro package provided to Ireland is less than meets the eye insofar as 17.5 bln comes from Ireland's pension reserves (representing an additional 10 bln more than was previously committed). The average interest rate of 5.8% appears to be a compromise as reports indicated Germany wanted a more punitive rate of 7% and Ireland wanted 5%.

Talk on Friday was that the rate could be closer to 6.7%. The 4 1/2 year extension of Greek's EU debt was a unexpected and likely paves the way for the rumored extension of the IMF debt as well. Europe also formalized the European Stability Mechanism (ESM) that willl replace that European Financial Stability Fund (EFSF) that expires in mid-2013. Collective action clauses will be included in sovereign issues that will allow a qualified majority to agrees to concessions and allow a orderly restructuring of sovereign debt with bond holders participating. At the same time, European officials drew back from the reports that circulated before the weekend that holders of senior (Irish) bank debt would lose part of their guarantees. One of the implications is subordinated debt holders would likely take a bigger haircut than the 80% seen as recently as last week.

In all, the European officials have not really gotten ahead of the curve of expectations. The approval of the Irish budget next week is still not a done deal and investors are not convinced the measures will make for a strong firewall around Portugal and, more importantly Spain. Meanwhile, the political situation in Europe is set to intensify, with the Irish government on the verge of collapsing and over the weekend the unlikely CDU-Green coalition in Hamburg collapsed. This means that Germany will hold at least seven state elections next year, leaving German domestic politics to have a large influence on the country's external stance. Meanwhile, shortly after the Italian budget is approved (Dec 10), Prime Minister Berlusconi faces a confidence vote that appears likely to lead to a national election early next year.

I continue to point out how well the US-German 2-year note differential has been tracking the euro-dollar exchange rate. The recent peak in Germany's favor took place on Oct 28 near 67 bp. The euro peaked a few days later on Nov 4.

The spread today is quoted just below 39 bp, the smallest German premium since Oct 6. In addition, I have been closely monitoring the premium the market pays for euro puts over euro calls. It gave us an early warning of that the euro longs were getting nervous. The measure bottomed (smallest premium for euro puts over calls) on October 18 and has collapsed.

The market is now paying the largest premium for euro puts since late June/early July. The euro's losses today are pushing it through the trend line drawn off the June and Aug lows (~$1.3210 today) and is conviningly falling below the 100-day moving average since early August. The next important chart points are seen in the $1.3080-$1.3130 area, which corresponds with a 50% retracement of the euro's rally from the $1.1877 multi-year low set in early June and the 200-day moving average.
Market Unconvinced, Euro Tumbles Market Unconvinced, Euro Tumbles Reviewed by Marc Chandler on November 29, 2010 Rating: 5
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