June 11th 2012: Weekly preview - Austerity backlash to reverse Euro gains
Following the Spanish bailout, Euro short covering and risk appetite relief is likely to dominate early in the week with the US dollar weakening sharply. Even if improved risk conditions can be sustained, and it’s a big if, the Euro has little chance of a sustained recovery and remains a huge sell on rallies. The decision to give Spain preferential treatment will fuel further resentment within the three countries already in receipt of rescue funds and increase political protests against austerity packages. There will, therefore, be strong pressure for the EU to sustain momentum and move more aggressively towards fiscal union, but this timetable is likely to be on a much longer-term scale and not satisfy market demands. With a dismal growth outlook and even greater pressure on a narrowing funding base, underlying resentment surrounding Euro-zone policies is likely to intensify at both ends of the spectrum after the Spain deal which, paradoxically, will increase the threat that the zone will splinter apart.
The Spanish bank-rescue proposals and wider fears surrounding the economy will inevitably dominate for much of the week. The Spanish government has finally been dragged kicking and screaming to the bailout table. There will inevitably be some relief that action has taken to prevent a banking collapse, but sentiment is liable to deteriorate rapidly during the week. The EU wants the funds to be financed through the ESM, but this has not yet even been ratified and there is the threat of rejection by Germany. Existing EFSF funds are already stretched beyond limit and there is also a huge problem that Spain’s contribution to the fund will no longer be available. As feared for months, the funding base will become ever more limited to support the growing bailout requirements with growing demands for collateral.
The banking bailout will also count as additional Spanish government debt and will push the debt/GDP ratio higher by at least 10% of GDP to above 90% which will put further pressure on the sovereign rating. The bailout may help narrow Spanish yield spreads to some extent, but there is still no mechanism in place to support the wider Spanish economy and secure a return to growth. The EU can sanction as many bailout packages as it likes, but if Spain and other countries can’t secure growth, there is no hope of ultimate redemption and political protests within Spain will intensify.
Inevitably, markets will also move beyond Spain with a renewed focus on Italy with speculation that it will be the next domino to fall. Italian markets will be watched extremely closely during the week. The Greek election due on Sunday 17th will also inevitably be a critical focus during the week, especially as it has acted as a trigger for the Spanish bank rescue with the EU fearing additional chaos following the Greek vote.
The Spanish bailout is certain to have a material impact on the domestic election campaign. The decision not to impose further harsh austerity plans on Spain could be justified on economic grounds as Spain was not running a serious budget deficit ahead of the financial collapse, but it will surely fuel additional resentment in Greece. In this context, there will be even less support for the existing Euro-zone bailout programme. There will also be major difficulties for European policymakers as they will not want to be seen as influencing the electorate. If, however, there are no promises of concessions to Greece, the message will be clear - we are prepared to let Greece exit the Euro.
Unwanted capital inflows will be the focus of two central bank meetings during the week. The Swiss National Bank will hold its latest quarterly meeting on Thursday and there will be major fear within the troika of Board members. At the last policy meeting in March, the market focus was on whether the central bank would raise the Euro minimum level from 1.20. This time around the focus is much more on whether the minimum level can even be sustained at current levels. The latest monthly data indicated a sharp increase in Swiss reserves which must have the been the result of persistent and increasingly heavy intervention to prevent renewed franc gains. The bank response this time will be very important in indicating the severity of the pressure on the minimum level and the extent of investor fear surrounding the Euro-zone. Any introduction of capital controls or negative interest rates would be a clear sign of severe tensions on both counts.
Similarly, the Bank of Japan has again faced the prospect of destabilising capital inflows as a refuge from Euro-zone and uncertain global outlook. There will be strong pressure on the Bank of Japan to announce further quantitative easing at the policy meeting. The strength of the yen is even more remarkable given the severe deterioration in longer-term fundamentals.
There will be some significant US economic data releases during the week, but they will certainly not be the dominant influence as they are unlikely to have a major impact on policymakers. The latest retail sales data is due on Tuesday with expectations of a relatively downbeat report while the University of Michigan consumer confidence data is due on Friday. A sharp decline in confidence could have some impact at the margins on Fed policy thinking. A weak consumer inflation reading on Thursday could also strengthen the theoretical case for further policy action.
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