Over the past few days, the spread between French and German bonds has widened to a record high of 114 basis points, as credit markets are becoming increasingly concerned about the country’s balance sheet. On Tuesday, Moody’s warned that it may put a negative outlook on France’s AAA credit rating if the costs for helping to bail out banks and other Eurozone members stretch its budget. Given the fact that the balance sheets of the three main French banks exceed the country’s GDP by more than 300 per cent, these financial institutions could in fact be floating icebergs of risk, threatening the country’s credit rating. Therefore, the task of creating an effective EFSF fund, which would act as a de facto European Treasury, could become even more complicated if France’s credit deteriorates further.
Meanwhile, in Germany the latest ZEW reading printed at -48.3, against an expected -44.7, as investors continued to worry that the slowdown in German economic activity could lead to a contraction in GDP by year end. Recent German PMI data has already signalled a contraction and if this Friday’s IFO number confirms the downward bias, sentiment could quickly turn negative as traders realise that markets are relying on Germany to backstop the Eurozone, just as the country’s economy risks sliding into a recession.
In short, the premise behind the Eurozone summit may be flawed. The bulls assume that Germany and France, which comprise Europe’s core, will be able to provide sufficient capital to rescue the region’s periphery. However, if the market suspects that the core is rotten the recent rally in euro-dollar will unwind all of its recent gains, taking the pair to a retest of the $1.3200 level and possibly $1.3000 by next week as investors lose faith.