Should the EU authorities be discussing restructuring?

This is the scenario that the credit markets are pricing in for Europe’s most financially weak states. While officials gather in Brussels before the 24/25 March summit, the chief area of discussion has been the creation of the ESM – European Stabilization Mechanism – which is a bit like a permanent bailout fund to help Eurozone members who are in financial trouble post July 2013.

But while the forex market has been cheered by the prospect of the long-term rescue fund especially one that can buy bonds in the primary market and is large enough to contain another financial crisis, the credit markets are less forgiving.

Irish 2-year bond yields surged past 10 per cent today after rumours that a troubled Irish lender had failed to pay a coupon on one of its bonds. Since that lender is majority owned by the government, it would essentially akin to a sovereign default. Crucially, this story was later proven to be false. But 2-year Irish bond yields are still higher than 10-year yields, leaving a very strange yield curve in its wake as you can see below. Investors are worried about a near-term default prior to the start of the ESM in 2013, so they are ramping up short-term risk premiums compared to the risk premium they charge to hold bonds further out the curve – when the ESM will be fully in place.

EU authorities are arguing about the future of the size of short-term bailout fund, the EFSF. Finland is the spanner in the works and does not support the extension in the EFSF. Unless all members agree the EFSF may not be increased by the end of this week’s EU summit. This leaves investors less comfortable to hold short-term debt as there is a reduced EU-backed safety net available to the troubled peripheral nations.

Irish 10-year – Irish 2-year bond yields:



What does this mean for the euro?

The spike higher in Irish 2-year yields to a euro-era high has coincided with the euro coming off the boil and bounces in the single currency remain fairly shallow on Tuesday.

While the Irish story that prompted panic today was false, it highlights what a future restructuring or default in one of the peripheral nations might look like and the impact on the markets: yields spike and euro comes under pressure.

So far, the euro has been able to brush off sovereign debt concerns and it rallied to its highest level in 13-months yesterday. We continue to believe that the euro is well supported due to two factors: 1, a favourable interest rate differential especially with the US and 2, Spain’s financial problems have been stabilising in recent weeks. If these conditions are sustained then we may see further gains back to the 1.5000 area by year-end. Based on the Ichimoku cloud, EURUSD is still in an uptrend above 1.3500.

However, if the market starts to think that the measures taken by the EU authorities are not sufficient: i.e. short-term liquidity measures are deemed inadequate creating a risk that a bailed out nation may default in the near-term while there is no process in place to deal with an orderly debt “restructuring” then we may see a more prolonged move lower in the euro.

Support levels in EURUSD comes in at 1.4000 (Tenkan line on cloud) then the 1.3480 February lows. In EURGBP: below 0.8650 this cross is vulnerable to a dip to the 0.8600 area and then toward 0.8500 – a cluster of daily moving averages that should provide good support.

Source: Forex.com

22.03.2011