Eurozone steps closer to the edge

Will Greece capitulate?

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It was a pivotal week for the Eurozone after Greece announced that it was heading back to the polls after the top three parities failed to form a coalition government. So now Greece is leaderless, there is a caretaker government in place but it won’t be able to enforce the austerity required to get the next tranche of bailout funds necessary for Greece to avoid running out of money in July. So as time runs out for Greece the European authorities have been clear: the upcoming election is a referendum on euro-membership. Either vote for pro bailout parties and stay in the currency bloc, or don’t and leave.

The EU authorities seem willing to sacrifice ECB losses from its Greek sovereign debt holdings (to the tune of $104bn), if Athens does not toe the austerity line. But while the EU authorities are not giving up ground when it comes to Greece there is a chance that the weekend’s G8 Summit in the US could lead to German Chancellor Merkel softening her stance on austerity and being more pro-growth. This is not due to Greece (which we think the EU is now willing to cut loose) but rather because of Spain.

Last week we got a taste of what Eurozone contagion may look like. After the Greek President said that Greek banks had seen deposits withdrawn at a quicker pace post the election result news came out that Bankia, a troubled Spanish lender, was also witnessing a jump in deposit withdrawals. Spanish savers can see what is going on in Athens, thus it is easy to understand why they would want to withdraw their money to the safety of a secure Swiss vault. Greek banks’ balance sheets were essentially decimated when Athens negotiated the private sector debt swap. The four biggest banks had a combined loss of nearly EU 30bn. That is roughly equivalent to the loss faced by Citibank at the peak of the financial crisis in 2009; however Greece’s economy is the equivalent of 0.3% of the US economy, which puts things into perspective. In Spain the problem is even more complex. Recapitalising the banks could push Spain towards a bailout. Yet, Spanish banks hold sovereign debt, so if Spain was to undergo a private sector debt haircut a la Greece, the banks would require even more support from European officials as the value of Spanish sovereign debt plummeted.

If Spain requires the same treatment as Greece that is effectively the end of the Eurozone as we know it. The only way to pull the Iberian nation back from the edge is by boosting growth. A plan to boost investment through the European Investment Bank may help growth levels recover and reduce pressure on the labour market. Thus, if Merkel agrees to slow down the pace of austerity at the same time as boosting investment in Europe’s periphery we could see a relief rally in the markets this week. As we have said in the past, politicians move slower than the markets so any sign that politicians are moving in the right direction could help to boost market sentiment.

Growth will also be in focus next week as preliminary PMI data for May is released. It is expected to increase slightly, but remain in contraction territory. After Q1 GDP remained flat the markets now expect growth to dip in Q2, but the key thing is how deep the contraction will be.

The euro managed to recover slightly at the end of last week after dipping below 1.2650 at one stage. The key support level to watch is 1.2624 – the January low. Below here there isn’t much support before 1.20. Although the situation is grave in the Eurozone, the volatility in the options market is not as high as it was in November. This suggests that the markets may be expecting the politicians and the ECB to step in if things get critical. Thus, any signs from Merkel that she is willing to re-assess her stance on austerity could be greeted with a relief rally in EURUSD. 1.2860/70 is a key resistance zone and 200-hour moving average.

Next page: Can the dollar extend its rally?

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