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Analyst Interview: Christopher Vecchio on Spain, AUD and EUR

Analyst Interview: Christopher Vecchio on Spain, AUD and EUR

2012-06-16 12:00:00
Christopher Vecchio, CFA, Senior Strategist

Is EU aid for Spanish banks sufficient to stabilize the economic situation in the country or will Spain eventually have to ask for a sovereign bailout as well?

With no hesitation, I can say that Spain will need a bailout. Consider this: Spanish banks hold nearly 65% of Spanish sovereign debt; so when the banks become distressed, so too does the Spanish sovereign. To this end, without structural fiscal changes that will alter the economy’s long-term prospects, further bailouts and liquidity injections will do little. While austerity has been painful, fiscal consolidation – lower government spending and higher taxes – is a necessary prescription not only in Europe, but in the United States as well. If bailouts and liquidity injections were the answer, shouldn’t these problems have been long-gone after the European Central Bank’s two longer-term refinancing operations (LTROs) in December 2011 and February 2012, totaling over €1 trillion? Clearly, more needs to be done; and it only appears that a crisis will force leaders into action.

Do you expect the EU debt crisis contagion to hit Italy so hard that it will also be asking for a bank bailout soon?

I’m more worried about some of the smaller dominos falling over first ahead of Italy. But Italy itself is very vulnerable. Just this week, Austrian Finance Minister Maria Fekter said that “Italy has to work its way out of its economic dilemma of very high deficits and debt, but of course it may be that, given the high rates Italy pays to refinance on markets, they too will need support.” This candidness is surprising, but in reality, she words should resonate among investors – European leaders throughout this process have consistently understated the severity of the crisis. If this global coordinated intervention actually occurs, it will bide time for Italy; at minimum, Italy has through August to avoid a bailout, if market conditions worsen; at maximum, Italy has through the end of the year.

Do you think that recent unfavorable US employment data might push the Fed into introducing more stimulus in June?

I don’t think the Federal Reserve is going to implement more easing for a few reasons. Primarily, it’s evident that quantitative easing isn’t the “panacea” (Chairman Ben Bernanke’s word choice) that the economy needs; a fiscal fix is needed. This, of course, is unlikely ahead of the November elections, but that doesn’t make it any more likely that more quantitative easing is coming. Secondly, core inflation is relatively sticky: as yesterday’s Consumer Price Index for May showed, core inflation (ex food and energy) maintains its 2.3% y/y pace, above consensus forecasts. With wage growth sticky as corporations continue to try and trim the “fat” and primp up earnings, a higher rate of inflation will further reduce disposable income in the US, and thus, the headline consumption figure. With consumption accounting for approximately 70% of headline GDP, the economy cannot afford to see a further deterioration in income. More quantitative easing will do this and Federal Reserve officials are well aware of this.

Instead, I expect the Fed to announce some form of a continuation of Operation Twist, though it will only go on for another few months. This might be the best play now, because it will continue to depress longer-term rates (which in turn, reduce mortgage rates which should, in theory, help the housing market). Without pre-committing to another large stimulus package is clearly best move right now, and quite frankly, not doing another round of quantitative easing is the best move. This will force fiscal policymakers to quicken the pace of their reforms and, over the long-term, provide the brightest future for the US economy. As the situation in Europe has taught us, countries that rely on cheap credit and assistance from loose monetary policies become overburdened fiscally. The US is headed in that direction, and it will accelerate if the Fed chooses to enact more quantitative easing.

Will the Aussie be able to break above parity or pair will break dynamic support that is forming triangle in 1h chart?

The AUDUSD indeed broke above the parity level but it doesn’t look like an organic break; instead, it was fueled by rumors of a global coordinated intervention yesterday late in the US cash equity session. Even today the AUDUSD continues to climb towards 1.0100, but this may be a red herring; the prospects for this weekend are increasingly bleak. Without global easing efforts, and especially no efforts from the Federal Reserve, it is very likely that the US Dollar regains some of its lost luster in the coming weeks. A ‘calm’ in the Euro-zone crisis and perhaps some more chatter about fiscal stimulus from China could keep the AUDUSD elevated though. To the upside, gains should be capped by 1.0130 (TL resistance on February and April highs) and 1.0250 (200-DMA). Lower, we look back towards parity, 0.9920, 0.9825, and 0.9750.

Do you see the Euro sustaining gains above 1.2550? What is your forecast for the coming week?

The EURUSD has indeed climbed above 1.2550 (currently at 1.2650) but this could be a short trip. The Greek elections pose a significant threat to the stability of the currency, and it is very likely that the results of the election are Euro-bearish (the only Euro-bullish scenario is that New Democracy, the pro-bailout party, wins the election outright and has enough support to have a parliamentary majority in its own right; I peg that a 10% chance of happening and dwindling). For argument’s sake, let’s assume the two likely outcomes are: New Democracy winning the election without majority; and Syriza winning the election without majority. Furthermore, under each scenario, let’s assume that there each outcome accompanies scenarios with: a global policy response; and one without. Thus: ND wins, global policy response; ND wins, no global policy response; Syriza wins, global policy response; Syriza wins, no global policy response.

In “The Brightest Outcome,” where New Democracy wins and there is a global policy response, the EURUSD could trade back up to 1.30 next week. Alternatively, in “The Darkest Outcome,” where Syriza wins and there is not global policy response (yet), the EURUSD could trade to fresh yearly lows near 1.20.

Is Gold liking the new QE?

Gold likes the new quantitative easing rumors, but it doesn’t love them. Gold (as well as the Japanese Yen) is a strong indicator for global easing expectations. Primarily, we’ve seen Gold trend higher (and the USDJPY trend lower) since the abysmal US Nonfarm Payrolls report for May, and Federal Reserve policy officials have certainly been beating the ‘more quantitative drum.’ Gold, during times of crisis, as we saw last fall, will sell-off more quickly than it will appreciate. Cash is king during times of crisis, so even if we see full-blown quantitative easing, if Europe is ‘burning,’ it’s unlikely Gold rallies back towards its all-time highs of $1921.17/oz anytime soon.

--- Written by Christopher Vecchio, Currency Analyst for DailyFX in an interview for

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