Barely two months after Greece received its second bailout, Eurozone market stress is back on the rise. Yet, unlike in other cases when such stress proved temporary, this time could reveal some painful similarities to spring 2011 as opposition from the hawks at the Federal Reserve grows. The combination of rebounding Eurozone bond yields, rising equity and currency volatility and a less accommodative Federal Reserve may be the required formula to drag EUR/USD below $1.29.
Spanish government bonds are becoming the latest new victim of bond traders’ typical one-country assault amid speculation that Spain will be the fourth recipient of a Eurozone bailout. At a time of deepening recession, Spanish authorities have selected “education and health” sectors for €10 billion in budget cuts. Cuts in these sectors have yet to prove successful or sustainable in the Eurozone. There is little surprise that the biggest Eurozone bond yield gainers are from nations that are not yet bailed out: Spain and Italy. Spain’s 10-year government bond yields are up 20% since the second round of the European Central Bank’s (ECB) Long Term Refinancing Operation (LTRO-2) was announced on Feb. 29. Also, Greek 10-year bond yields are up 22% since the country was granted its second bailout on March 9.
“The fear gauges” (below) shows how option-based volatilities, whether VIX (volatility on S&P 500) or 1-month volatility on EUR/USD, have deepened their decline (a positive dynamic for SP50 and EUR/USD) in the period between LTRO-1 (Dec. 20) and LTRO-2 (Feb. 29). Also during that period, market sentiment was boosted by liquidity-creating purchases from the Bank of England and the Bank of Japan, as well as further easing from the BRICs. Consequently, EUR/USD’s stabilization was attained as euro option 1-month volatility tumbled to its lowest since January 2008.
But this is now changing. Today, the hawks at the Fed are increasingly silencing the insistence by the doves to see more data improvement, while the ECB has not mentioned the LTRO in more than a month. The combination of protracted gains in Spanish government bond yields and rebounding volatilities (EUR 1-month volatility & VIX) would be needed to break through the euro’s floor of $1.29. The possible fundamental culprits for such an occurrence could be the following: IMF demanding further budget cuts from Spain’s planned €10 billion; new hawkish dissent at the June FOMC meeting or negative surprises in U.S. earnings.
And with U.S. earnings emerging on the back of a 10% rise in the U.S. dollar accumulating over the last seven months, the prospects for a negative translation effect on U.S. multinationals (more than 20% of S&P 500) may add more scrutiny to the Eurozone uncertainty factor.
On the Fed quantitative easing (QE) front, most Fed watchers agree that some form is required beyond this summer. Whether it entails MBS purchases, and how effective their use will be in maintaining consistency with a new form of Operation Twist (no net new issuance), remains to be seen. Currency markets meanwhile continue to subscribe to the notion that only outright QE from the Fed (increasingly unlikely) remains a key requirement for any notable gains in EUR/USD. Despite the unraveling challenges from Spain’s budget and the lack of clarity regarding the true size of the new and expanded Eurozone bailout fund, EUR/USD requires more bad news to break below $1.30 and ultimately drop under $1.28. Conversely, intermittent selloffs in the USD emerging from new hints of further Fed asset purchases seem to have tapered off around the $1.35 resistance in EUR/USD.
And with the months of April/May having proven negative for equities and EUR/USD in both 2010 and 2011, the prospects of a repeat in 2012 are considerable. The aforementioned dynamics could well serve as the fundamental catalysts.
Ashraf Laidi is Chief Global Strategist at FX Solutions/City Index, founder of AshrafLaidi.com and author of “Currency Trading & Intermarket Analysis.”