Weekly Spotlight: Europe Fading in the Rear View

Talking Points
• Greek Crisis Spreads like Wildfire
• Euro-zone Likely to Slip Back into Recession by Year End
• Hungary Default Unlikely but Comments Stir Fears

Recently, investors witnessed a surprise by the European Central Bank in which policy makers purchased government debt in the secondary market. Why is the euro still under pressure? Indeed, the 16 member euro area recovered from its worst downturn since the Second World War; however, the region may slip back into recession by the end of this year as boiling budget deficits lead governments to phase out stimulus measures. In the midst of European woes thus far and going forward, the bloc will likely face unconstructive comments from policy makers and downgrades from rating agencies.

So much for a happy Friday in Europe... After Fitch downgraded Spain’s long term foreign and local currency issue default ratings from “AAA” to “AA+” on Friday, May 28th, Hungary added additional weight onto the euro the following Friday. Prime Minister Orban said that talks of a default are “not an exaggeration” because the previous administration “manipulated” figures. As a result, credit default swaps on sovereign bonds rallied to a record amid speculation that Europe’s debt crisis will worsen after Hungary stated that the region is in a “very grave situation.” However, it is noteworthy that Hungary will unlikely default as the new Fidesz government is expected to stick closely to the IMF deficit target in order to restore its credibility. Indeed, it is obvious that the Greek crisis has spread similarly to what OECD Secretary General Angel Gurria in late April referred to as Ebola. Besides Greece, Portugal, Ireland, Spain, add France onto your list. The yield on the euro-zone’s second largest economy's 10 year notes is at 3.06%, up from a low of 2.84% on May 25th. This adds concerns for France as economic activity may stall later on this year after the country responded to the bloc’s debt problems by tightening fiscal policy earlier than expected.

Looking at the economic docket for this past week, retail sales unexpectedly tumbled to the lowest level since October 2008 as European woes lead consumers to scale back spending. Meanwhile, the unemployment rate in the 16 member euro area rose to 10.1 percent, marking the highest level in twelve years, with the breakdown of the report showing that the jobless rate in Spain rose to 19.7 percent from 19.5 percent in March. Going forward, consolidation measures amongst indebted countries will likely weigh on employment, and may cause retail sales to decline further. Away from last week’s jobless data, the unemployment rate for the euro-zone has been steadily climbing for the last two years, reaching double digits for the first time since 1998.

What can we expect going forward?

The key event for the euro-area this week is going to be the ECB meeting on June 10th, and policy makers are likely to elaborate on their decision to engage in additional credit easing. Additionally, we may see the euro continue to lose ground against the U.S. dollar as global markets witness a flight to safety.

The yield on Greek 10 year notes are up 29 basis points in the past 5 days, and have rallied 260 basis points to 8.11% 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 12, 44, and 28 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 0.67, down from 0.83 last week. This is a signal that the EU crisis which was almost directly driving risk aversion is tapering off.


Purchasing Power Parity
As of 06/08/2010                                                                                 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 1.32. As of today, the EUR/USD exchange rate stands at 1.1942, and it looks apparent that the pair may test support at 1.18. It is noteworthy that a break below this level exposes support at 1.15. Additionally, the Purchasing Power Parity now stands at 5.67%, 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
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Michael Wright is the author of FX Headlines, Fundamentals vs. Technical's, Weekly Spotlight, and Forex Trading Weekly Forecast