Currencies | May 26 2011
– ECB resistance to Greek restructuring suggesting EUR downside risk
– A stronger USD would put pressure on commodity prices
– Even Aussie banks may suffer the fallout
By Greg Peel
Further signs of a slowing in the US economic recovery, further evidence of Chinese tightening measures having an impact, and even a new volcano are weighing on the minds of stock market investors at present. But none is more concerning than the seemingly eternal problem of peripheral eurozone sovereign debt. Since Greece came back into the spotlight yet again, Wall Street indices, for example, having been tracking euro movements with near perfect correlation.
It was not that long ago that markets were anticipating a second rate rise from the European Central Bank given evidence of rising inflation in the eurozone. The expectation that the ECB would outrun the Fed in the tightening game meant the world became long euro and short US dollars. Many observers, including FNArena, warned that ECB language had suggested a second hike was not a given, and that if that were the case a strong bounce in the US dollar was on the cards, which in turn would shake the commodity speculators.
And that's exactly what happened – no rate rise, the euro tanked, the greenback bounced and commodity prices plunged back to more fundamentally supportive levels. The next step was for Germany to suggest a “soft” restructuring of Greek debt, which brought a nod of agreement from the IMF.
Given that most of the market has long thought a Greek restructuring inevitable, there was a chance such an outcome would actually provide support for the euro. Uncertainty is a trader's biggest fear, and a quick resolution would also have relieved some of the risk of contagion through to Portugal and Ireland. But any relief was brief, because pretty quickly France voiced its disagreement on restructuring, and the ECB rejected the notion out of hand. Thus uncertainty has reigned ever since, and now fears over Spain and even Italy have entered the mix.
Greece is currently supported by an EU-IMF bail-out fund, so while Greek debt yields have blown out to total junk levels of 25% the government will not need to refinance via the market any time soon. But the EU-IMF assumption was that the bail-out would mean Greek yields would drift back down, not explode. Eventually Greece will have to tap into market funds.
And this is what has the ECB offering staunch resistance, because it will be the ECB left to carry the can. Officials suggest that a restructuring of Greek debt will scare potential bond investors away for years and that would mean the central bank would be left as the only source of Greek finance. At present, under bail-out conditions, the ECB is only “temporarily” accepting Greek debt as collateral.
CBA analysts are not convinced bond investors would completely abandon Greece but rather that a price could always be found. However too high a price would undermine current Greek efforts to reduce its deficit, including rapid implementation of government business privatisation. At present, Greece is doing all it can, in the face of political unrest, to satisfy IMF conditions. The IMF is due to review those efforts in mid June.
While uncertainty reigns in the meantime, CBA is expecting further euro weakness. An obvious target would be US$1.3685 (3% below current) being the currency's 200-day moving average and, just to excite the tea leaf readers further, would represent a Fibonacci retracement. CBA is suggesting selling into any euro rallies until the IMF report comes out or some resolution is agreed upon in the meantime.
If the euro does fall further, it implies further strength in the US dollar. More dollar strength would reassert pressure on commodity prices which are currently trying to bounce back after their big plunge, aided by bullish calls on oil and base metals from Goldman Sachs and others. There would have to be some solid fundamental support in the demand/supply equation for commodity prices to resist a stronger base currency, but with the US looking weak and China trying to be weak that's not a given.
The other consideration from an Australian stock market point of view is that which has been assisting recent weakness, being the Moody's downgrade of the Big Four bank credit ratings.
One wonders why suddenly now Moody's would chose to focus on the indirect risk from Europe, being an implicit rise in cost to the banks of offshore funding based on risk spreads widening globally, given it's over a year now since Greece hit the headlines and the Aussie banks are getting closer each day to their funding cost peaks. One can only assume the recent extensive blow-outs in peripheral euro-debt yields, along with uncertainty now raised over Spain and Italy, tipped the balance.
Either way, Moody's has managed to undermine the global perception that the Aussie banks are among the strongest in the world, having proven their worth by making it through the GFC without too many injuries. Were the euro to fall further on ongoing Greek uncertainty, Aussie bank share prices may yet come under more pressure.
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