FYI | Jun 12 2012
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
Throughout this crisis Europe’s periphery has been personified as a pack of domino’s – if one falls then others will follow. This time a year ago Spain wasn’t even considered a “peripheral” nation, having the fourth largest economy in the currency bloc. Unfortunately that economy was propped up by an unsustainable property bubble that burst in 2008 leading directly to last weekend’s EU 100bn bailout for its troubled banking sector.
So now the attention turns to the next domino, and unfortunately for the EU authorities, far from ease up pressure on Italian bond yields, Spain’s bailout may have made Italian debt less attractive. There are two reasons why investors may choose not to buy Italian debt: 1, the sovereign debt crisis has been caused by either property crashes (Ireland and Spain) or unsustainable public finances (Greece). In this environment Italy’s 120% debt-to-GDP ratio won’t wash with bond investors, thus it’s hard to see a permanent decline in Italy’s bond yields while debt levels remain so high. 2, Spain’s bailout has opened a debate about the position of private sector bondholders in the pecking order if Spain one day defaults. If Spain gets funds from the ESM then private bond holders are subordinate to European institutions – a real turn off for investors. It is not beyond the realm of possibility that Italy may need a bailout one day, hence investors are immediately suspicious of owning Italian debt, hence its 10-year bond yield jumped to above 6% at one stage today, which is the highest level since January. This is concerning since Italy plans to auction debt on Wednesday and Thursday, which will be a test in confidence towards Mario Monti’s efforts to bring down debt levels in the coming years.
But investors need to know how close the next domino is to falling? Italy’s bond yields might not be in danger territory right now, but there are some worrying signs that investors may turn their attentions to Rome. The spread between Spanish and Italian debt has started to narrow, as Italian bond yields have been rising at a faster pace than Spanish debt. This is definitely a chart I will be watching over the coming days as rising Italian yields could cause another bout of market volatility and bring this crisis to an even more dangerous phase.
Spanish and Italian 10-year government bond yield spread chart, from the start of this year.
Source: Bloomberg and Forex.com
The impact on the euro:
The single currency had a strong move higher versus the dollar post the Spanish bailout, but within a few hours of the European session sentiment towards the euro was flagging. There were a few signs that the bailout to Spanish banks won’t be enough to spur a move towards 1.30 in EURUSD, firstly the sharp spike higher in EURUSD at the Tokyo open was not broad-based, for example EURGBP retreated and so did EURAUD. Secondly, because the euro bulls could not sustain gains above 1.2625 in EURUSD.
Thus, we think that EURUSD could trade with a negative bias as we lead up to the Greek election at the end of this week and the EU summit at the end of June. The details of the bailout for Spain could also erode sentiment especially if it causes tension with Ireland, Portugal and Greece who may try to re-negotiate their bailout terms, adding to investor uncertainty. Today’s close is going to be important, below 1.2580 opens the way to 1.2510- the daily pivot. Next up is 1.2445, a recent low and then 1.2330. 1.2625, the double top from last week, remains a key resistance zone.
EURUSD: hourly chart
Source: Forex.com
Disclaimer: The views expressed are the author's, not FNArena's (see our disclaimer)
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