Weekly Spotlight - Europe’s Debt Crisis Remains in Headlines

During the first quarter of 2010, Cajasur posted a 114 million lost subsequent to chalking up 596 million in 2009, largely due to the bank’s exposure to the 2008 crisis as about half of its equity portfolio was concentrated in the property sector. Looking ahead, we may continue to see further turmoil from the region as savings banks (known as cajas in the region) begin to merge with one another amid the collapse of the housing boom. Also weighing on the euro the first half of the week was an article from the Financial Times that said China is reviewing its holdings of euro zone debt in the wake of the crisis that has swept through the region’s bond markets.

As Europe’s largest trading partner, it is very unlikely that the world’s second largest economy will let Europe twist in the wind during this vital time. Thus, China is prone to keep their reserve allocation to euro assets at approximately 25%, as Chinese officials went onto say that they “believe that with the joint efforts of the international community, the euro zone will be able to overcome its difficulties and maintain the steady and healthy developments of European financial markets.” And just when market participants were looking to have a quiet trade heading into the Memorial Day weekend in the U.S., Fitch downgraded Spain’s long-term foreign and local currency issuer default ratings (IDR) to “AA+” from “AAA,” and went onto say that Spain’s growth going forward will be hampered by the austerity package as it attempts to lower its deficit.

What to look out for?

Greece! Greece! Greece! First and foremost, the credibility of Greece’s government is sure to be the main focus for investors as the austerity measures call for increases in wage cuts, freezes on pensions, and increases in sales taxes ranging from alcohol and tobacco, and fuel.  However, without domestic political stability in Greece, it will be very hard to raise taxes; thus, it will be very difficult to pay the interest on their debt. Now, thanks to impotence, governments that are highly indebted like Greece may drag the world economy lower.

Even more worrisome for the long term, is a recent paper from the Bank for International Settlements (BIS) which illustrates the extreme instability of public finance amongst the “PIGS” (Portugal, Italy, Greece, and Spain). The report’s projects shows that will lead to debt explosions in each of these countries over the next 30 years. If indeed policy does not change, the report predicts that Portuguese debt-to-GDP will soar to 275 percent, the Irish will climb to 300 percent, while the Greek and Spanish debt to economic activity will jump 400 and 300 percent of GDP respectively over the next 30 years. Therefore, we may see these countries increasingly borrow more money in order to pay the interest on the money which was already borrowed. Nonetheless, the euro will likely remain under pressure as Greece’s crisis spreads like Ebola to its euro-area members. 



The yield on Greek 10 year notes are up 11 basis points in the past 5 days, and have rallied 237 basis points to 7.71% in the past year, making Greece’s borrowing costs more expensive. Additionally, Italy’s, Portugal’s and Spain’s 10 year bonds have come under pressure this week, with the countries yield climbing 21, 16, and 18 basis points respectively.

Credit default swaps on 10 year government bonds for “PIGS” have pushed higher from my report last week (Euro-Zone Debt Crisis Lingers, Euro Remains under Pressure). Indeed, insurance against highly indebted countries in Western Europe is gaining momentum as market participants bet that Greece and its neighbors are heading towards default. Furthermore, Italy’s and Greece’s debt to GDP of approximately 115% in 2009 are additional concerns for investors as their bad debt will now have to be restructured. Comparatively to the U.S. where bad debt is in the private sector, for the Europeans, bad debt is in the public sector, and the nearly $1 trillion life line calls for passing on this debt onto the taxpayers of solvent states. One of the main problems with Europe is that peripheral states cannot keep up with the interest on the money that they borrow.


The 21-day correlation between the EURUSD and the MSCI World Stock Index now stands at 0.83, a signal EU crisis is still driving risk aversion.



Purchasing Power Parity
As of 05/27/2010                                                                                 PPP as of 11/27/2009   


The euro looks to continue its southern descent against the U.S. dollar that began earlier this year amid the media frenzy surrounding the brewing sovereign debt crisis in Europe. From a technical standpoint, the pair has broken below an eight year rising trend which I noted earlier this month when the pair was trading at 1.2885. As of today, the EUR/USD exchange rate stands at 1.2268, and it looks apparent that the pair may bottom out around 1.200 as the European debt crisis lingers. Additionally, the Purchasing Power Parity now stands at 6.06%, down from its extreme level of 24.35% in the November, a signal that the euro may bottom out in the near term versus the U.S. dollar. It is also worth mentioning that the daily studies are illustrating that the downward move maybe overdone. 


Weekly Glossary

Credit Default Swap
A credit default swap (CDS) is a type of insurance that allows an investor to buy insurance against a bond issued by a country or a company. In detail, the buyer makes standard premium payments until the end of the contract as long as the borrower does not default. However, if the borrower defaults, the CDS holder is paid by the seller of the protection and the buyer then ceases to pay the payments. Market participants may use Credit Default Swaps for speculative purposes, betting against the solvency of the borrower, and in return receiving capital if it defaults. On the other hand, traders may use CDS contracts to hedge their investments.


MSCI World Stock Index
The MSCI Index is the collective of global companies which includes small, micro, mid, and large size companies.

Purchasing Power Parity (PPP)
One of the oldest and most basic fundamental approaches to determine the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. We compare values in PP to determine how much each currency is under – or over-valued against the U.S. dollar.

Chicago Board Options Exchange Volatility Index (VIX)
The symbol for the Chicago Board Options Exchange Volatility index, the VIX is one of the most used measures of implied volatility of the S&P 500 index options. The objective of the VIX is to estimate the implied volatility of the S&P 500 over the next 30 days, on an annualized basis. Investors may use the index in tandem with recent fundamental developments in order speculate reverses or continuation of upward/downward trend.

Each week we provide a thorough analysis of the fundamental theme largely impacting the global markets and outlay the potential outcome for a Specific Currency Pair.

Written by Michael Wright, Currency Analyst
What do you think about this report? Email me at mwright@fxcm.com