The market mercilessly pressed its case on the non-sustainability of officialdom’s approach to the Greece/EuroZone periphery situation through late April and into early May until the EU/IMF and ECB finally pulled together and felt forced into getting ahead of the curve. After an extremely weak ECB press conference on May 6 with Trichet declaring that bond purchases by the ECB had not even been discussed, the bottom completely fell out of risk markets.
Then, on the weekend of May 8-9, a massive EUR 750 billion package was announced that would provide enough funds to not only cover the shorter term funding exigencies in Greece (already addressed by the earlier rescue package), but also massive funds aimed at countering contagion risks to Portugal, Spain and other countries.
Most importantly for driving market prices lower on the sovereign debt at the periphery, the ECB was granted authority to purchase public and private debt on the free market, though any debt purchases were to be sterilized and not done by outright debt monetization (not yet, anyway, the cynics among us might add).
While the announced package saw the immediate effect hoped for by its creators and risk markets around the world that had been dragged down by the Euro-crisis - namely a one off explosive rally in asset prices on the Monday after the package was announced - very pressing questions remain for the EuroZone and the Euro, if not the rest of the world as well. These include the following:
Austerity still needed. Even with a bailout here, Greece will need to continue along a path of unprecedented austerity, without being able to lean back on a devaluation as it has in cycles past. Will Greece follow through and will Spain and Portugal follow through when it’s their turn? To access the funds, the countries will have to agree to fiscal restraint and possibly review by the IMF. Economists have estimated (based on a Reuters article) that Portugal, Spain and Ireland alone need EUR 444 billion just to get through the end of 2012 assuming they had no access to the bond market.
What about debt restructuring? This is really a critical part of the austerity question – the debts need restructuring if these countries – particularly Greece and Portugal are to be able to dig themselves out of their mess – this package offers no mention of restructuring and the losses that must be taken at some point on this debt. This would hamper the recovery and credit markets due to the large losses this would entail for banks all across Europe.
Disgruntled creditor nations. The bailout package is particularly unpopular in Germany, which will pay the largest chunk of the bailout funds . While one can argue that bailing out the periphery is also a bailout of German banks and the debt they own in the PIGS countries, the population doesn’t see it that way. Already, Merkel’s CDU lost control of the upper house of parliament in a regional election that took place just as the package was being announced. As well, part of the package includes up to EUR 250 billion from the IMF, a US- sponsored institution. Could this fact enter into the US political scene as well? Hasn’t the US issued enough debt bailing out itself?
Our look at a trade-weighted Euro basket vs. the development in PIGS 10-year spreads. This chart was taken on the Monday after the announced bailout package. The package did reverse the blowoff in spread-widening, but there’s a lot more tightening that needs to take place to get the spreads back to their historic norm. Open questions remain on whether the EuroZone project will survive if the nations at the periphery don’t carry through the necessary steps to reach a sustainable fiscal trajectory.
Besides these considerations, which could yet see the market losing faith in the EuroZone project again in the weeks and months to come, the Euro will be under pressure from a monetary policy angle (idea of a rate hike off the table basically forever from market’s point of view as austerity means deflation and very low rates) and from an investor confidence angle – especially from reserve managers of major central banks. These longer term investors will think twice about any further diversification of their reserves into Euro.
The situation has led us to front-load our forecast for the EURUSD further drop. A fall to 1.2500 again (with significant slippage potential) is in the cards for the nearest 1-3 month term, and we lower our 12-month forecast to 1.1500 for EURUSD. As we have said in the past, there is no good way out of this situation for the EuroZone – either take the pain and the fall now or take an expensive rain-check on the confrontation with the debt demons. The rain-check must eventually be cashed, however, and that knowledge will continue to pressure the Euro for some time, even if a chaotic demise of the Euro has now been kicked much further down the road with the huge bailout package.
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