- Eurozone stabilization likely temporary
- Italy and Spain are downgraded
- US jobs data obscures future weakness
Eurozone stabilization likely temporary
After a terrible start to the week, market sentiment rebounded sharply on word that EU leaders were working on a plan to recapitalize Eurozone banks to weather credit losses on peripheral EU debt. The key here is that they’re still discussing how to go about it and have no concrete plan yet. It’s hoped that this weekend’s meeting between German Chancellor Merkel and French President Sarkozy will yield a workable blueprint, but doubts over financial sector stability are likely to persist, especially after Friday’s rating downgrades to Spain and Italy . (This weekend also likely sees the finalized break-up of French/Belgian bank Dexia, the first major casualty of the debt crisis.)
Merkel backed off earlier comments that national governments would provide recapitalization funds and most recently indicated that banks should seek to raise private capital first. Failing that (and only EU-core banks are likely able to raise funds in markets), it would be up to national governments to provide capital. Merkel appears insistent that the EFSF should only be used as a last resort. That brings up several problems. National governments already struggling under excessive debt burdens would be forced to borrow even more to bail out their banks. France , in particular, is concerned it may lose its AAA credit rating if it’s compelled to borrow more to fund French banks. Peripheral governments may find it next to impossible to access markets in this effort. Which leaves the EFSF as the final source of funding, but the facility is currently too small, and plans to leverage it appear to be failing. It also raises the question of whether an EU-wide bank recapitalization makes a sovereign default more likely, as banks would theoretically be more able to withstand losses. Which brings us back to the primary fear, namely that an uncontrolled Greek default could trigger a domino effect, potentially triggering a global financial crisis. Against this backdrop, we continue to look for opportunities to sell EUR on strength as well as risk assets in general.
EUR/USD price action for the week (a doji on weekly candlesticks) suggests immediate downside potential is waning and a period of consolidation is likely to develop. There are many EU meetings to come in the weeks ahead, and markets seem inclined to give EU leaders the benefit of the doubt until concrete proposals are fielded. The Oct. 17-18 EU summit is expected to see the bank recapitalization framework finalized, but discussions in advance should continue to provide market-moving headlines. Also, next week will see Slovakia ’s vote to ratify the enlarged EFSF agreed to back in July; the vote is expected to pass, though the government there may fold. We think prospects for bank recapitalization should prevent EUR from weakening directly further, but that longer-term prospects should also contain rebounds. This suggests trading a range on the long-side from between 1.31/32 and from the short side between 1.35/36 for the next few weeks, followed by a break to the downside.
Italy and Spain are downgraded
Following the close of markets in Europe on Friday, Fitch ratings agency announced credit downgrades to Italy (one notch from AA- to A+) and Spain (two notches from AA+ to AA-). Both countries’ outlooks remain negative, meaning further downgrades are possible. Fitch kept Portugal at BBB- while it completes its review in the 4Q, potentially seeing a cut to junk status. The timing of the move was a surprise, but downgrades are not unexpected these days and markets still think credit rating agencies are behind the curve. But the actions reinforce the view that Eurozone problems continue to have global repercussions, as EUR, stocks and commodities all reversed post-NFP gains and the USD rebounded.
European markets did not have the chance to react to the downgrades and there is some potential for another sell-off to start next week. But with a weekend to digest the downgrades, and depending on the outcome of the Merkel/Sarko meeting on Sunday, we think global stocks and FX may see further consolidation. We will be closely watching Asian markets Monday open, as they have been increasingly among the most panicky regions in the sell-off of the last few months.
Next page: U.S. jobs data unclear