IRELAND MAY BE ENDING THE RISK TRADE

DIRECTOR OF CURRENCY RESEARCH, GFT

JUST take that castor oil and swallow it. It’s good for you.” That prescription no longer seems to be working in the periphery economies of Europe. From Portugal to Ireland, the public is starting to rebel against the fiscal austerity measures imposed by the EU and the IMF and the politicians are responding.

Last week, the Portuguese parliament rejected an austerity budget, triggering the resignation of the Prime Minister Jose Socrates, while putting the country in financial limbo just as it faces its largest issuance of sovereign debt this year. Little wonder that the credit rating agency Standard & Poor’s warned it may downgrade Portugal for the third time in a week. Meanwhile, Irish government officials roiled the currency markets over the weekend when the minister of agriculture Simon Coveney stated that the government wants “a sustainable and comprehensive solution that involves recapitalisation, but also an element of burden sharing as well as a funding package for Irish banks.”

Under the agreement reached last year, Ireland can impose losses on a bank’s junior debt, but the current Irish government is seeking to amend that arrangement by imposing new debt restructuring terms on senior unsecured bondholders.

The government is awaiting the results of new stress tests due tomorrow, which are expected to show a capital shortfall of another 25bn euros on the banks’ balance sheets. The Irish economy contracted 1.6 per cent in the fourth quarter of 2010. As its citizens suffer, the government is under pressure to curtail its seemingly never-ending bank bailout program.

UK and German banks are likely to be the biggest losers in any possible restructuring proposal. Any move by the Irish could trigger a chain reaction that would instantly weaken UK and European banks and force another infusion of capital from their respective governments. The currency markets have ignored this possibility, with speculators ploughing head on into the risk trade. However, the risk-on dynamic can change rapidly if the European banking sector comes under threat. Long euro-dollar and sterling-dollar positions are very vulnerable at the moment to a steep sell-off.