Europe at Risk for a “Double-Dip” Recession by the End of the Year

Talking Points
•    European Financial Markets Begin to Panic
•    EU Stress Tests May Not Disclose Much Information
•    Insurance Against Greek Default Rises to Two Year High

Though Greece remains in the headlines at the moment, it is a matter of time before countries like Spain and Portugal tap into the EU-IMF life line of approximately 1 trillion dollars as banks face higher borrowing costs. The three month EURIBOR has continued its northern journey as banks in the 16 member euro area find it difficult to secure liquid funding as lenders panic. Though they are not as severe as the Lehman collapse, strains in the European banking sector are coming to life amid fears of counterparty default. However, this adds increasing concerns for the region as lenders are incurring higher borrowing costs in euro and dollar funding. As Barclay’s Capital Analyst states, “The system is just not working [in Europe]. We’re approaching the third year of liquidity support and still the market cannot survive unaided.

Greece is now entering in what looks to be the next step in its crisis as insurance against the country defaulting reached a two year high. Despite being one of the bloc’s smallest members, market participants fear that a Greek default could spread like Ebola. Subsequent to Greece, traders are beginning to be apprehensive of Spain as the unemployment rate in the first quarter topped 20.0 percent, while its fiscal deficit to GDP reached double digits. Furthermore, traders are speculating that Greece’s woes will spillover onto Portugal and Italy. Even though it is one of the smaller countries in the Euro-Zone, a default by Greece may lead France and Germany (two of the larger countries in the bloc) to enter a new recession as their banks have the largest exposure to the indebted nation.

Recently, European policy makers agreed to stress tests, which are expected to be released in July. However, these tests may do little to calm the knee jerk in the markets. Some economists fear that the outcome will not properly weigh the banks’ relative strengths. At the same time, there is a likelihood that the results may not include a sufficient amount of banks needed to get a clear picture of the health in the European markets. In 2009, the stress tests were not published as policy makers used a single standard with a scenario involving a 2.7 percent decline in economic activity in 2010 and a 12 percent unemployment rate scenario. As of late, it is unclear of what will happen to banks that “fail” these stress tests measures.

All in all, as uncertainty in the 16 member euro area lingers, we are likely to see the European Central Bank keep rates near zero for the rest of the year. Looking ahead, market participants are weighing in a zero percent chance that policy makers will hike borrowing costs twenty five basis points at its next rate decision meeting on July 8th, according to the Credit Suisse overnight index swaps.
 


The three month EURIBOR rate, one of the euro-zone’s principal money market indicators continues to hold near yearly highs on the back of credit risk conditions, rather than lack of ECB liquidity. The EURIBOR3MD is fixed at 0.761 percent, a high last seen since approximately October 2009. 



The yield on Greek 10 year notes are up 67 basis points in the past 5 days, and have rallied 541 basis points to 10.44% in the past year, making Greece’s borrowing costs more expensive. Additionally, Portuguese and Spanish 10 year bonds have come under pressure this week, with the countries yield climbing 10 and 8 basis points respectively.



Credit default swaps on 10 year government bonds for “PIGS” have pushed higher from last week. 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 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 1.22 and it looks apparent that the pair will rebound on the back of a much needed correction before pushing lower. It is also noteworthy that a break below the 20-day SMA, which has held up pretty modestly recently will expose the yearly low. Additionally, the Purchasing Power Parity now stands at 8.71%, 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.


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 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