Euro Rallies as Greece Out of Danger, but Watch Spain and Italy

The Euro rallied as the Greek Parliament approved key austerity measures, and Greece is all but guaranteed to receive its next tranche from the EU/IMF. Yet the real danger to the euro is contagion risk to Spain and Italy, and the next steps could decide the euro’s fate over the medium term.

Short-term focus will remain on Greece in the coming weeks as it takes the next steps to receive a €12 billion payment. Yet to focus solely on the relatively small Greek economy is to miss the much bigger risk to regional stability in larger euro zone countries Spain and Italy.

Euro Zone Economies Ranked by Gross Domestic Product

Spain’s public debt topped €679 billion in the first quarter of 2011, hitting a 13 year high and jumping from 40% of Gross Domestic Product to 63.4% in only 3 years. The country’s unemployment has surged above 20% and the housing and banking sectors are still reeling from the 2008 global recession. All indicators point to a growing risk of contagion.

Spain and Italy, Public Debt as Percentage of GDP

Even as news released of bond yields climbing to an 11 year high, Spanish Finance Minister Salgado calmed nervous investors saying that “Spain is financing itself very well” adding that “demand for government bonds always outstripped supply by about four times. Therefore we are not, nor will we be on the brink of any bailout.”

Yet contagion risks are such that bond investors increasingly doubt Spain’s abilities to pay its debts in full. In fact the spread between Spanish 10-year Bond Yields versus the benchmark German equivalent now trades at its widest in the history of the euro—underlining fears of Spanish debt difficulties.

Spanish 10-year Bond Yields versus German 10-Year Bund Yield

While the structure of Italy’s economic troubles differ from Spain’s, the world’s third largest debt market has drawn worries from member countries that a failure to reduce their astronomical public debt level could be devastating. Italy is facing a €1.8 trillion debt burden, representing a staggering 120% of GDP and second only to Greece’s 140%. Unemployment has risen sharply since the global crisis and banks are straddled with bad loans.

However, global economies face lower risk from exposure to Italy’s debt since majority of their obligations are domestically held, unlike that of Greece. A sovereign default in Italy does not appear to be a real risk. Yet if deficit reduction measures are not introduced in the near term, the euro zone country will see its creditworthiness threatened under a tremendous debt to GDP ratio.

Aware of lower default risks, bond investors have not sent Italian 10-year Bond Yields beyond the psychologically significant 5 percent mark. Yet the spread against benchmark German issues trades near a euro era record.

Italian 10-Year Bond Yield versus German 10-Year Bund Yield

The downside risk for the euro currency remains high. Investors will continue to be cautious as economic outlook for Spain and Italy remains bleak and public debt levels quite elevated.

We predict that the euro could continue to gain through the near term. Yet there are clear medium-term risks to euro zone stability, and the EURUSD will remain extremely sensitive to news over Greece through the coming weeks.

With contagion spreading, any hint of solvency risks to Euro Zone giants Spain and Italy could spell real trouble for the euro and is a key medium-term risk to EUR outlook.

Written by David Rodriguez, Quantitative Strategist and Sonu Sadarangani, DailyFX Research Team

To contact the authors of this report, e-mail drodriguez@dailyfx.com