The euro blew through its prior support level of 1.2960 easily as contagion fears grow. Bailouts don’t prevent contagions and that is what investors are deeply afraid of.
Moody’s has put Portugal on review for downgrade sparking fears that there will now be TWO countries poised for same downward spiral as Greece.
Fear is an aggressive behavior especially when it seeps into the core of the financial markets. Part of the reason why currencies are so trending is because when uncertainties grow, investors won’t hesitate to sell. However realistically, the risk of rating agencies downgrading Spanish and Portuguese debt to junk is minimal. Spain and Portugal do not have the same funding problems as Greece. The premium that investors demand to hold 10 year Greek debt over German bunds hit a record high of 700bp while the premium for Portuguese debt is 280bp and 121bp for Spanish debt, far below Greek levels. Yet these facts are not be enough to sooth investors who are preparing for the worst and will cringe at even a one notch downgrade.
There are still Unanswered Questions:
(1) Will all Governments approve the package
(2) Greek public unrest likely to continue /worsen
(3) Will it work / does it solve the underlying problem ( probably not)
(4) Contagion to other euro zone members.
As a result, its worthwhile to take a look at the next support levels in the euro. Here’s a weekly chart illustrating the strong possibility of the euro falling to 1.25.
If you have watched the interviews that I recently posted, you will know I have been bearish euros for sometime. However now that the single currency has hit a 1 year low and is closing in on the psychologically important 1.30 level, you may be wondering how much further can it fall. Unfortunately I believe that the 1.30 level is more of a psychologically important level than a technical one. The currency pair should break it easily and fall to its “real” support level of 1.2960 (see chart below). Until the Germans officially vote in favor of the bailout package for Greece, the euro will have a tough time rallying.
If the EU/IMF announcement this weekend was aimed at supporting the euro, it has failed miserably. The euro has continued to weaken because of the abundance of unanswered questions. Here are just a few of those questions:
– Will Parliamentary Approval be Achieved?
– What will be the final package size?
– How quickly will aid come?
– How painful will the austerity package be for Greece?
– How much social strife will it cause?
– Will market turn on Spain, Portugal, Ireland and Italy?
– Will the ECB Completely Change the Rulebook because of Greece?
The concern ranges from how long it will take before Greece will receive funds to the possibility of contagion. Even though Eurozone finance ministers have approved a EUR110 billion bailout package, there still needs to be Parliamentary approval from individual nations that will affect the speed and size of the final bailout. Eventually Germany will come through because underneath all of the political backtracking, the government knows that in order to avoid a more damaging and embarrassing bailout of German banks, they need to bailout Greece first. There will be strikes and protests, but at the end of the day, the aid is needed to stabilize the region’s economy, support investor sentiment and prevent the euro from falling further. There is even talk that the Germans could be fast tracking their vote. However even if Greece is successfully bailed out, investors could quickly turn on countries like Spain, Portugal, Italy and Ireland especially if there are additional downgrades by rating agencies. This morning, there are rumors floating around that Spain could ask for an E280 billion bailout. As a result of these developments, the European Central Bank has amended their collateral rules for the second time because of Greece.
With fiscal stability still not achieved, there is a good chance that ECB President Trichet will remain dovish when he delivers his post ECB meeting press conference on Thursday, which is part of the reason why the euro has sold off today.
Finally everyone is watching Greek bond spreads. Here is a chart that I created on Bloomberg which shows the relationship between the EUR/USD and the 10 year yield premium that investors demand for holding Greek bonds over German bunds. As you can see, the yield has hit approximately 600bp and poised to blow out even further. Given its close relationship with the euro, I expect that to minimally mean a break of the 1.30 level.
Since I am stuck in a snow storm in Michigan, I want to take this opportunity to republish an article that I posted on FX360.com earlier this week to explain Credit Default Swap Spreads – a term that is used often in the financial media these days:
What are Credit Default Swaps ?
A credit swap is like an insurance contract. The buyer of a credit default swap receives a payment if the underlying (company or country) defaults which basically means that he or she is buying insurance for a default. In return, the seller will require regular payments from the buyer. The best way to describe a 5 -year credit default swap is to compare it to a 5 year term life insurance contract. You make a payment at regular periods of time so that if the “credit event” or “death” occurs within 5 years, a lump sum is paid. If it does not happen, then the seller simply retains to payment and your “insurance” expires.
What are Credit Default Swap Spreads ?
Credit default swap spreads are the cost of the protection expressed as an annualized percent of the notional amount. So for example if the 5-year swap spread on Greek debt is 400 basis points it means that it costs 4 percent of the notional to protect against a default of Greek government debt within 5 years. On a $10 million bond, investors would require an annualized payment of $400,000 in this case to be willing to bear the risk of Greece defaulting on their bonds.
Why is this Important for Forex Traders ?