One of my colleagues wrote last week: “You can’t spell Spain without pain,” and truer words have not been spoken. As currency traders return to a full week of work after the Easter break, euro-dollar finds itself under pressure as credit spreads in the region once again widen out.
After a few months of relative calm in the wake of the European Central Bank’s (ECB) long-term refinancing operations (LTRO), the markets are once again concerned about the credit quality of Eurozone peripheral debt, with yields on Spain’s benchmark 10-year bonds rising to 6.10 per cent – their highest level since last December. Meanwhile the yield on German 10-year bunds collapsed to 1.65 per cent on Monday as flight to safety flows drove the return to record lows. This widening out of spreads between the periphery and the core has been the primary reason for the sell off in euro-dollar over the past several days.
The rise in Spanish yields occurred despite the fact that the country’s fiscal authorities agreed to steep budget austerity measures. Yet some analysts have pointed that it is precisely the focus on austerity that has capital markets deeply concerned. The fear is that austerity may destroy the Spanish economy, and that it will drive Spain either out of the euro or into the arms of the European Stability Mechanism.
Euro-dollar therefore appears to be caught in a Catch-22 situation, as markets on the one hand demand fiscal control and austerity, and on the other become highly concerned that the medecine will kill the patient. In short, austerity may kill Spain’s economy and therefore no one wants to lend to a dying government.
Last time the CDS spreads widened out by 150 points, euro-dollar lost 10 big figures. This time, the decline has been much more modest as the pair has only fallen by 5 cents off its recent highs. Yet Ray Dalio, the famed manager of Bridgewater Associates, one of the most profitable hedge funds in world, believes that there is more pain to come. Dalio argues that the LTROs may have temporarily brought down Spanish borrowing costs, but they did not translate more interbank lending, leaving Spain in worse shape than before. Furthermore, Spanish banks have little appetite for more government bonds while foreign banks continue to be net sellers of Spanish paper.
All of this should prove quite interesting this Thursday as Spain attempts to auction off approximately €4bn of 10, 5 and 3-year bonds. The auction will no doubt be the focus of the currency market and its results could determine the near term direction of euro-dollar.
For the time being, the $1.3000 level appears to be strong support for the single currency, which has remained relatively buoyant despite the onslaught of negative news over the past several weeks. However, if this Thursday’s auction proves to be a disappointment, euro-dollar could not only break the $1.3000 support but ultimately tumble as low as $1.2500 over the next few weeks, as credit concerns and fears of fracture of the Eurozone return with a vengeance.