Is the rally over for good?

Sentiment has continued to dip during the European session as the market has woken up to the fact that central banks won’t prop up the markets during the latest bout of volatility. The rally of the last few days was born on shaky foundations as investors priced in the prospect that global authorities would act to ease market stress. But after the ECB passed the baton to European governments to sort out the crisis, the Bank of England remained on hold and Bernanke told the markets not to hold their breath waiting for more QE, it was only the PBOC in China who cut interest rates for the first time in 3 years. Hence the sell-off as investors re-assesses the prospect of dealing with uncertainty in the currency bloc without official help.

Breaking the link between banks and sovereigns

A downgrade of Spain’s sovereign rating by rating agency Fitch from A to BBB, two notches from junk, added to Eurozone worries, as did a raft of extremely weak Greek economic data and rumours about an emergency EU press conference this weekend to talk about re-capitalising Spain’s banks. The Spanish downgrade probably should have been expected as its bond yields have risen and its banking sector liabilities continue to threaten sovereign finances. Fitch revised up its estimate of the cost to re-capitalise Spain’s banking sector to EU 60-100bn from EU 30bn originally.

To call, or not to call…

The rumour of a conference call tomorrow where EU leaders would discuss the potential for a Spanish aid request to support its banking sector has not helped improve sentiment. Spain has denied the call will take place, even though not long ago its PM was calling for official help. The key question to ask now is: can the Eurozone break the link between banks and the stability of Spain’s sovereign finances? Will official aid help Spanish bond yields to retreat and allow its credit rating to be revised higher? If aid is granted to cover banks’ liabilities what will the conditions be? If the conditions are even more tough rounds of austerity that could weigh on economic growth then we could see yields continue to creep higher as this may have a detrimental effect on government finances. Thus, it’s not clear-cut how Spain’s banking problem can be resolved, but at this stage it appears that aid will come at a high financial cost that Madrid may not be willing to pay. This is unlikely to help risky assets to sustain any rallies, and may cause the euro to meander lower on a broad-based basis.

Greek data was dismal. The markets didn’t seem to expect anything less. The economy contracted at a 6.5% annual rate in the first quarter, much worse than the flat rate for the Eurozone as a whole. Industrial production sunk 2.2% in April and in May prices fell from 1.9% to 1.4%. To compound its problems, Greece is now at risk of falling into deflation.

Could Germany soften her stance?

Not even Germany was unscathed. Although the Bundesbank revised up its 2012 growth forecast for Germany to 1% from its prior estimate of 0.6%, it said that a Greek exit and the Spanish banking crisis could have adverse effects on the European powerhouse. Added to that export data for April fell 1.7%, worse than the 0.7% fall expected. While this data may have been impacted by the Easter holiday, the deteriorating crisis in the currency bloc can weigh on Germany as other Eurozone members remain important trading partners, so as they suffer it can impact Germany. This could be the clincher to get Angela Merkel to soften her stance and potentially allow Eurozone funds to be deployed to help Spain’s struggling banks. After all, helping to re-capitalise Bankia etc. is a lot cheaper than funding Spain indefinitely.

Market Moves:

In the absence of that much economic data during the session, the market has been moved by headline risk from Europe and continues to digest the “disappointment” from Bernanke. However, we believe that the lows from last week are now key support zones: 1.2350 in EURUSD, 0.9700 in AUDUSD, $1,550 in gold and 78.00 in USDJPY. Of course these levels could be breached if we get a stray headline or a failed bond auction; however we think that the “tail risks” – Spain needing a bailout and Greece leaving the Eurozone are already pretty much priced in by the market, which could limit further downside. Thus we could range trade into the Greek elections on the 17th and the EU summit at the end of the month.

In EURUSD it looks like 1.2625 (a double top) is a key resistance zone, while 1.2350 could cap the downside. Added to that GBPUSD could be trapped within 1.5350 – 1.5500 range. The SPX 500 may struggle to make gains above 1,340/50, while 1,300 could cap the downside. The outlook remains murky, but unless we get some negative fundamental news it’s hard to see us breaking to fresh lows in the near term. Added to that, some second tier economic data from the US and no Fed speakers of note could keep things quiet this afternoon as we head into the weekend.

Source: Forex.com

08.06.2012