Next week, the ECB will conducting their second long term refinancing operation. The impact of their first LTRO was significant – in fact, it sparked the stock market rally. If the uptake next week is anywhere close to EUR1 trillion, we could see a similar reaction. The following chart shows how the EUR/USD, the S&P 500 and the German DAX performed since last month’s operation. The vertical line points out the date of the LTRO. Impressive how far a bit of liquidity can go eh?
Since Standard & Poor’s cut the ratings of 9 Eurozone countries, the euro has done nothing but rally. One of the main reasons why the EUR/USD has been so resilient is because the downgrades had very little impact on European bond yields. French and Spanish bond yields have increased but by less than a tenth of a percent while Italian bond yields decreased since the S&P announcement. The following table compares the 10 year bond yield and 5 year CDS spreads of key EZ nations today vs. before S&P’s announcement. Five year credit default spreads rose, representing an increase in risk premium but the uptick was nominal. The biggest consequence of sovereign downgrades are higher yields and borrowing costs but based upon 10 year bond yield spreads, troubled European nations have been spared from Armageddon for the time being.
Contagion fears have rattled the markets today with everyone worried about the crisis spreading to Italy. The reason why investors are so nervous today is because the Italian economy and its total amount of debt outstanding far exceeds that of Greece. The following chart shows the total amount of foreign claims on each of the PIIGS. As you can see, exposure to Italy is the highest which explains why it is such a big problem. A default by Greece would truly be a Lehman scale event.
Why has the rally in the EUR been so lackluster? Because there are a still
4 3 more hurdles to overcome before we can put the Greek debt crisis behind us.
The Greeks have jumped over 2 hoops on their own with one more expected to be cleared once the Greek implementation vote is completed this afternoon.
1. Win no Confidence Vote
2. Get Parliament to Approve Austerity Plan
3. Get Parliament to Approve Implementation Procedure
4. Get EU/IMF to Release Next Tranche of Aid
5. EU/IMF Needs to Come up With a Second Rescue Plan for Greece
6. Rating Agencies need to be convinced that the Rescue Plan does not constitute a default
The Greeks have lived up to their end of the bargain by passing the Austerity Package that the EU and IMF demanded and now the ball is in their court. When European Finance Ministers meet on July 3rd, we expect them approve the next bailout tranche, worth EUR12 billion. They will then start to discuss options to ensure continued financing for Greece. Thankfully, investors are not operating in a vacuum because the bond rollover plan proposed by France has received widespread approval and support by the markets. Getting rating agencies to feel the same way will be the main challenge but crafting the second bailout package will not be easy either because even if there is enough participation in the rollover, Greece will still be asked to find buyers for EUR50 billion worth of state owned assets.