beathespread

From Katy Lien

Thin liquidity has meant quite a bit of volatility for the EUR/USD  today. The euro fell steeply during the European trading session, recovered during the first half of the shortened North American only to plunge near the close following news that S&P downgraded Belgium.  Short squeezes rarely last on thin volumes days and this is particularly true when fundamentals factors are stacked high against a rally in the euro.  Over the past 48 hours, we have heard nothing but bad news out of Europe. S&P downgraded Belgium, Fitch downgraded Portugal, Moody’s downgraded Hungary and Italy’s bond auction was a dismal failure that drove 10 year Italian bond yields to a record high and the EUR/USD  to its lowest level in 7 weeks. This morning, Italy sold six month bills at a record yield of 6.5 percent and zero coupon bonds at an average yield of 7.814 percent.   In response, 10 year Italian bond yields rose high of 7.322 percent, a painfully expensive level for Italy to borrow. We have warned that one of the most immediate consequences of rapidly rising bond yields are downgrades by rating agencies. We already saw how much damage lower ratings for smaller countries such as Greece, Belgium, Portugal and Hungary can have on euro.  A downgrade of Italy or France would surely drive the EUR/USD  below 1.30. European officials need to act quickly if they want to prevent Spanish yields from rising to Italian levels and to save Italy from paying more than 8 percent to borrow. Italian bond yields are moving into very dangerous territory and if nothing is done to reverse the rise in borrowing costs, we could get fall into a vicious cycle where borrowing costs rise, triggering more downgrades which then cause yields to increase further and the euro to slide deeper into negative territory.

Eurobonds: Quick Solution?

There is a “quick fix” according to ECB member Paramo, through the issuance of Eurobonds but we all know how Germany feels about the idea. Not only is it impossible under the current EU Treaty which is not as much of problem, since Germany and France are open to Treaty changes but the Germans vehemently oppose jointly guaranteed Eurobonds which would drive their borrowing costs significantly higher as Eurozone debt is collectivized.  German Chancellor Merkel has been unwavering in her opposition to the bonds even after a failed auction earlier this week. She may have no choice in the matter if the crisis escalates but if Germany agrees to the issuance of the bonds, it would only be with strict rules imposed on EZ nations to limit their debt and deficit and impose sanctions if they do not meet the requirements. In the meantime, we believe the Germans would more readily support increasing their EFSF commitments before issuing Eurobonds. 

Like the U.S., Germany also has a number of important economic releases on the calendar next week including confidence numbers, retail sales and employment but the headlines will be what matters. A number of European officials are speaking next week while EU Finance Ministers meeting in Brussels to discuss ways to end the crisis. 

From Katy Lien: