Germany to the rescue?

This is the fifth day without a firm government in place for Greece; if a coalition is not found soon then we could be heading back to the polls, which open up the possibility of a prolonged period of Greek political instability. There was some hope this morning of the Conservatives forming a coalition with the Socialists and other moderate pro-bailout parties that would have a mandate to govern until 2014. This helped to lift the euro from its daily lows; however for a sustained rally in risk we need to get a firm commitment that a “moderate” pro-European government will take the reins of power in Athens. Unless that happens then the markets are likely to remain jittery.

Mixed signals

The markets are particularly cloudy today. Some bullish reversal patterns that formed yesterday were negated during the Asia session as a wave of selling pressure caused risk to sell off and EURUSD to test 1.2900 – a key option barrier level. However, the headline about a potential coalition government forming in Greece was enough to pick EURUSD up off the lows and re-test 1.2940. However, 1.2950 now remains key resistance and unless we can get a weekly close above this level it looks like the single currency could be headed for further declines.

We know that traders like trends, so the moment that EURUSD broke out of the bottom of its recent range below 1.30 the risk was always for further selling of the single currency. This pair has been trapped in a tight range for so long that investors are unlikely to give up on a trend lightly. Thus, any strength maybe sold into, although we would be concerned about the potential for further losses in EURUSD if we get above 1.30 in the coming days.

Madrid’s persistent headache

The future direction of the single currency relies on two things: 1, politicians in Athens forming a moderate coalition, which could be greeted by a relief rally in the financial markets. 2, Spain’s banking sector. The government has already had to inject state funds into Bankia and is now the bank’s largest shareholder. It also announced some measures yesterday to try and bolster its struggling lenders. It will require them to hold capital worth 40% of the total EU 180bn of real estate loans that currently clog up Spanish banks’ balance sheets. It will also bring in outside inspectors from the EU to monitor stress tests and banks’ ability to raise capital. The government is expected to announce fresh measures later today, however it is unlikely to draw a line under the banking crisis in Spain and it remains hard to see how the banks can raise capital without government support.

The million dollar question is can Spain afford to bail out its banks without requiring a bailout for itself? This is a question we have asked in the past and remains one of the key variables for the sustainability of the currency bloc, in our opinion. The latest reports from Madrid suggest that banks will be forced to park their toxic real estate loans into the “bad banks” which could deepen losses already on their books – so things in Spain could get worse before they get better, which may cause another leg higher in Spanish bond yields.

Is Germany shifting its stance?

On that note, Spanish bond yields have continued to fall today and are below 6%. This drop may be as a result of a slight improvement in risk sentiment yesterday and also signs that officials in Berlin may be willing to allow inflation to increase, especially wage growth, throughout Germany to try and help “re-balance” the currency bloc. This may open the way to rate cuts from the ECB in the coming months, which could help boost peripheral bond markets in the short-term. We need to hear more about this, but if Germany is softening its stance towards inflation this is a major shift in the currency bloc and would deal with the key structural issues that have so far been neglected during this crisis.

Forecasts – a fool’s game

Growth is in focus next week as the Eurozone GDP for Q1 is released. The EU released its spring economic forecasts this morning. It assumes a Brent price of $116.80 per barrel this year (it is currently below this) and for EURUSD to average 1.31. It sees unemployment in the currency bloc at 11% both this year and next and for GDP to fall 0.3% this year, before growing at 1% next year. The EU said the economy is in a “mild recession”, however that depends on where you are in the currency bloc. Germany is doing well, but somewhere like Spain and Portugal are in a painful economic state. We believe that the 2013 GDP forecast seems a bit optimistic to us and we could see downward revisions later this year. The overall budget deficit in the currency bloc is expected to be 3.2% of GDP this year and 2.9% next, which is fairly healthy especially when compared to the US and the UK. Read more about this in our Week Ahead report. These forecasts had little immediate impact on the markets. Investors may expect a wave of revisions as the outlook remains cloudy that long-term forecasting seems a bit like a fool’s game.

Market Moves:

Weekly closes will be especially important today. As we said 1.2950 is the key to watch out for in EURUSD, while AUDUSD has also come under pressure this week. The bears have made an attempt at parity this week, but have been re-buffed so far. We know that 1.0050 was a prior support.

The markets reacted badly to the news of an unexpected loss at US bank JP Morgan during the Asia session, thus we could see some volatility at the US open as investors across the Atlantic digest the news. Right now US equity futures are poised to open slightly lower. 1,350 is a key level for the SPX right now. If we fall below here then we may not find support until 1,280 – the 200-day sma, 1,380 is likely to cap the upside. Overall market direction is likely to come from Europe and the banking sector in particular. The Bloomberg 500 banks index is off its lows from this week but s/t rallies have lacked conviction, which seems to be the main theme today.

Source: Forex.com

11.05.2012