DailyFX Research

By Christopher Vecchio Published: April 17, 2012

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Euro Outlook: Spanish Crisis Headlines Dominate Foreseeable Future

The European sovereign debt crisis cooled in the first quarter but has since started to rear its ugly head once more - this time in Spain. These headlines will be sticking around for at least the next three-months. The European sovereign debt crisis has been the most important story of the past two years and thats not a title it appears to be willing to let go of. As we now enter the third year of the crisis May 2010 being when mainstream media first started offering daily headlines on the hallowed PIIGS theres an argument to be made that little sustainable progress has been accomplished. Greece was the first member nation to declare default in the Euro-zones thirteen year-plus history earlier this year, and now its looking increasingly likely that any one of the other PIIGS could fall. However, of the remaining four, there are only two that really matter.

Spain: The Next Act of the Saga

While there was much fuss made over the Greek sovereign debt crisis, the true issue for global markets was the loss of confidence that would be experienced and if that would spread to other countries debt markets. Broadly speaking this phenomenon is known as contagion. For several weeks, especially in the wake of the European Central Banks first longer-term refinancing operation in late-December, it appeared the tides of the crisis had been turned away as liquidity issues were no longer prevalent; Europe was saved, the crisis is over exclaimed French President Nicolas Sarkozy, and contagion was contained. However, in late-March, the crisis reappeared. Newly minted Spanish Prime Minister Mariano Rajoy and his government announced that Spain had missed its 2011 budget deficit goal of 6.0 percent debt-to-GDP ratio and would meet the 2012 goal of 4.4 percent. The 8.51 percent debt-to-GDP ratio in 2011 prompted the Spanish government to ask the European Union to raise its 2012 goal to 5.3 percent. With fewer and fewer services to cut to help reign in the budget deficit, the Rajoy government has been and remains trapped: does it implement more austerity, risking social upheaval amid a labor class struggling with a 23 percent unemployment rate? Or does it offer reassurances to market participants hoping that investors remain patient? So far the latter course has been chosen and market participants have not reacted kindly. The Spanish 10year bond yield climbed by 89.7-basis points in early-April, from 5.259 percent to 6.156 percent, in response to the new governments proposed measures. Since then, an additional 10 billion worth of cuts to education, healthcare, and other governmental services has helped soothe uneasy bond holders. The 10-year yield has receded back to 5.822 percent as of April 18, but more key obstacles remain: bond auctions. Spain has numerous bond auctions over the coming weeks, but one of the most important comes on April 19 when the country will auction off 2-year and 10-year bonds at 5.85 percent. Considering all of the recent drama surrounding the Euro-zones fourth-largest economy, its important to sift through Spains borrowing tendencies to see if theres reason for concern. In the wake of the ECBs LTRO, theres been one noticeable trend: the Spanish government has been auctioning off substantially more short-term debt than longer-term debt thus far in 2012. What does this mean and why is it a good gauge for Euro-zone confidence?

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The ECBs LTROs dealt out over 1 trillion over three months from December 2011 through February 2012, providing unlimited funds at ultra-cheap rates for cash-strapped Euro-zone financial institutions. At a 1 percent funding rate for three years, there was little reason not to take the funds given the obvious arbitrage opportunity at the time: take the borrowed funds and buy short-term, high yielding periphery sovereign debt. This plan only makes sense within the three-year window of the ECBs LTRO, however; outside of this window the ECB isnt offering loans and thus liquidity is a potential problem beyond that time horizon. It is important to thus watch the shorter-term auctions, especially those that have maturities within the LTRO window, as weak auctions would signal a substantial loss of confidence give the liquidity injections.

The LTRO: Will the ECB Inject More?

As markets slid uncontrollably in November, it was becoming clearer and clearer that liquidity issues were rampant across Europe. The Euribor-OIS 3-month spread, the rate at which Euro-zone banks lend unsecured funds to one another, was at its highest level in over two and a half years in December 2011 a clear indication that banks were worried about liquidity issues. However, after the first LTRO was announced in early-December and completed in late-December, liquidity has no longer been an issue. At the time of writing, the Euribor-OIS 3-month spread has collapsed from 1.006 on December first to 0.395 on April 18, indicating that the LTRO accomplished its primary task of solving the credit crunch. Beyond liquidity issues, the LTROs have had a secondary objective: the ECB wants banks using the LTRO to take those funds and purchase periphery sovereign debt. Instead of the ECB intervening directly in the markets, theyve provided the intervention funding to banks. The mindset was, and remains, from the ECBs perspective: you buy the debt, well provide you the capital. This worked for a time as the over 1 trillion worth of funds successfully caused interest rates of periphery Euro-zone nations to fall for the first six-weeks of 2012. As noted earlier, the Spanish 10-year bond yield climbed by 89.7-basis points in early-April, from 5.259 percent to 6.156 percent, and remains elevated at 5.822 percent as of April 18. Now the question is if the ECB will introduce a third LTRO to help the crisis, or if it will reopen its securities market program (SMP), its tool it uses to intervene in the secondary bond markets directly. At the April 4 ECB rate decision, President Mario Draghi addressed this very issue, saying that all [the ECBs] non-standard measures are temporary in nature, further adding that in order to support confidence, sustainable growth and employment, the governing council calls on governments to restore sound fiscal positions. Now, is it in the ECBs best interest to see periphery yields capped? Of course it is; this would allow banks time to recoup some of their losses and for governments to implement the necessary measures to stem the crisis. Is it in their best interest to be the prevailing force behind lower borrowing costs? No; by consistently bailing out weak countries the ECB is cultivating an environment of moral hazard, in which governments dont implement the harsh fiscal reform and continue to rely on the ECB. This is the main dilemma the ECB faces. Along these lines, President Draghi has thus far avoided discussing another LTRO. He has been adamant about governments making the necessary reforms to solve the crisis rather than continue to kick the can down the road with further liquidity injections. The International Monetary Fund supports this view, with the IMFs director of capital-markets department stating on April 18 that the ECB cant be the only game in town.
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If governments are unable to implement the necessary reforms to solve the crisis and the ECB remains on the sidelines, the Euro is likely going to struggle going forward and the crisis could spiral out of control. The most bullish scenario for the Euro is for governments to implement the necessary fiscal reforms and for the ECB to remain on the sidelines; further liquidity injections will dilute the value of the Euro. It is worth noting that a recessing Euro-zone economy will weigh on the Euros upside in the future, and weaker growth is a symptom of the harsh austerity measures being implemented across the continent. All considered, the fundamental picture is more likely to cater to the bearish scenario than the bullish scenario at present time, but as long as sovereign bond yields remain capped, the Euro will likely trade sideways to down over the next quarter.

Euro Technical Forecast

A closer look at the longer-term chart shows the market locked in a well defined downtrend since posting record highs just over 1.6000 back in 2008. An initial low was recorded in October 2008 by 1.2330, followed by a lower top at 1.5145 in November 2009, a lower low at 1.1875 in June 2010 and the latest anticipated lower top by 1.4940 in April 2011. The topside failure in 2011 now opens the door for the current downside extension which should ultimately look to retest and eventually break below the 1.1875, June 2010 lows to confirm the next lower top at 1.4940 and potentially open a deeper drop towards 1.1500.

As such, our outlook for the third quarter of 2012 is predominantly bearish while the market adheres to the broader underlying downtrend, and we would expect to see a move towards 1.2000 at a minimum before considering the potential for any meaningful recovery. In the interim, any rallies should therefore continue to be very well capped, with overbought short-term rallies viewed as compelling opportunities to look to build on short positions. Ultimately, only a 2-week close back above 1.3500 would delay outlook and give reason for concern.
Trading on margin carries a high level of risk, and may not be suitable for all investors. Any opinions, news, research, analyses, prices, or other information contained is provided as general market commentary, and does not constitute investment advice. DailyFX assumes no responsibility for errors, inaccuracies or omissions in these materials, and will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information. DailyFX does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

DailyFX Research

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--- Written by Christopher Vecchio, Currency Analyst and Joel Kruger, Technical Strategist for DailyFX.com To join these authors distribution lists, e-mail subject line Distribution List to cvecchio@dailyfx.com and joelskruger@dailyfx.com Follow these authors on twitter at http://www.twitter.com/CVecchioFX and http://www.twitter.com/JoelKruger

Trading on margin carries a high level of risk, and may not be suitable for all investors. Any opinions, news, research, analyses, prices, or other information contained is provided as general market commentary, and does not constitute investment advice. DailyFX assumes no responsibility for errors, inaccuracies or omissions in these materials, and will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information. DailyFX does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.