Key Week for the Euro next week

“Helicopter” Ben

Even though “Helicopter” Ben Bernanke and his band of merry members that make up the U.S. Federal Reserve have been throwing as much money as they can at the U.S. economy during the last 3 years, more recently with Operation Twist and what has been coined QE3 or “QE infinity”, the U.S. Dollar, interestingly, been relatively stable, or at the very least, able to avoid heavy losses. This is contrary to what many people would have expected given the increasing supply of dollars. Conventional economic wisdom is that money printing is bad for a currency’s strength. The reason behind the strong Dollar over the last 12 months lies more outside the U.S. than inside…

The world economy has been struggling to grow during the last 18 months and in fact, the US has been one of the strongest performers. Secondly, as is very evident in the US Treasury markets, investors still fear taking on too  much risk, which is why US 10 year bond yields are sub 2%. This demand for Treasuries has also shored up the dollar and acted as a counter balance against the negative impact monetary easing has on a currency.

On the other side of the Atlantic, the Euro has been unstable this year, weighed down by serious concerns about the addressability of the sovereign debt woes of various of the peripheral economies initially with Greece at the epicentre and more latterly with Spain & even Italy where bond yields rose to dangerously high levels this summer. We seem the see-saw between optimism about the Eurozone but a few days later we inevitably return to the same starting point with all the same issues back on the table to be discussed. Yet again.

The European crisis has acted as a dampener on the sustained strength seen in the Euro over the last 10 years and so the flip side of the equation is that it boosts the US Dollar. Germany’s insistence on ever more austerity for the embattled currencies has caused even more damaged to some of these economies and which is now spilling over into more vocal social unrest, not unsurprisingly with youth unemployment in Spain and Greece estimated at upto 50%. We don’t expect this situation to change dramatically over the next 12 months and so expect weakness will continue to prevail in the Euro, certainly on a medium term perspective. As for the shorter term however, we are a little more bullish. Let’s see why…

Spanish debt and her latest bond issues

Spanish Prime Minister Rajoy

Confounding many speculators in recent months, Spain has been successful in elling government bonds at reasonable yields. This week the country was able to complete the issue of bonds to close their funding needs for the current year. They will now start issuing debt for next year. Unlike what many commentators were expecting, they were able to survive without a full bailout and as a consequence, bond yields are now quite substantially lower than a few months ago. Currently, a 10-year debt issue would cost 5.69%, a good 2% lower than the worst of the summer shakedown in the bond markets and rate that no doubt puts a  big smile in Prime Minister Rajoy’s face.

Speculators were caught out by Mario Draghi’s back stopping of the Euro in the early autumn. The simple threat of intervention by the ECB was enough to attract many investors to the higher yields Spanish debt offers. Instead of buying a 10-year bond from Germany, yielding 1.41%, investors re-appraised the risk in Spanish bonds and so caused a compression in yields. We don’t really see Spain needing a bailout anytime soon and yields will most likely continue to fall and stabilise into the New Year and so likely giving some additional support to the Euro.

European PMI data better than expected

Finally some positive economic data come out of Europe last week. The latest PMI data revealed some improvement in demand, especially in manufacturing across the Eurozone. To be sure, the numbers are still below 50, but still they were better than expected, giving a boost to the Euro this week. IFO numbers for Germany were also released above expectations.

Negotiations on Greece

The most important trigger for the Euro is the negotiations about the next Greek tranche of funds. Before giving the necessary funds to the embattled country, the IMF is trying to negotiate on the exact terms as it becomes ever more apparent taht Greece will never been able to repay its debts. The country now has an accumulated debt load of €340 billion, corresponding to 176% of GDP and despite all austerity measures to reduce it, next year’s debt will be even worse.

Austerity in Greece has failed and simply left the country in a deep recession making it even more difficult to reduce debt. Greece is now most likely trying to negotiate with lenders some type of haircut. It seems it obvious to everyone but Ms Merkely that Greece will never been able to recover if creditors don’t accept a big haircut, and for its people, the sooner the better.

Next week we expect some type of interim solution will be delivered and we don’t believe the troika will dare stop the funding to Greece.

With the above scenario in mind we think the Euro has the potential to push back over 1.30 as we approach year end, especially with equities rising once more.