Despite the relative lack of major economic news this morning in North America, markets are not lacking in their voracity at the start of the week. Markets have been selling off due to uncertainty about what will come next followed by a slight rally heading in to lunch. Much of the early price action can be attributed to The European Three Ring Circus which has come to town, and investors the world over are trying to pay attention to multiple factors all at the same time. So ladies and gentleman, step right up, and witness the never ending crisis displayed to you in simultaneous fashion.
Taking center stage, we have bond yields of Spain and Italy. Often times viewed as a “fear indicator” for holding euros, 10-Year bond yields across Europe are edging ever higher, but Spain and Italy are of particular interest. When yields grow higher than 7% for countries of their size, it is viewed as being unsustainable as they would have to collect more taxes to pay off debt. Being that European citizens are already taxed in the 40%-50% range, there isn’t a lot of room for them to be taxed more without risking the government being overthrown. Unfortunately, if investors are demanding more interest to be paid in order to loan to these countries, there are few options of recourse. With interest rates in Spain currently at around 7.5%, and Italy at around 6.3%, the situation is coming to a head rather quickly, and it may trigger a reaction from the European Central Bank. In the past, the ECB has stepped in and issued Long Term Refinancing Operations on two separate occasions to effectively loan money to European banks at low rates in the hopes that those banks would in turn loan money to their struggling nations; thereby earning more interest than what they borrowed it at to start. And in the past, it worked; banks had liquidity, interest rates fell, and everyone was happy, at least temporarily. Therefore, it is logical to assume the ECB may step in again to offer a third round of LTRO to calm the markets in the hopes that this time may be different, and Europe can start to get their house in order.
In one of the other rings of the European Three Ring Circus you can find the constant chatter about a country leaving the Eurozone. The most popular candidate for expulsion from the monetary union has been Greece, but kicking a country out of the EZ would be a very long and drawn out legal matter, so it wouldn’t appease the masses quickly enough. Therefore, this is unlikely to happen unless Greece left voluntarily. Considering that a pro-euro government was recently elected in Greece, the likelihood of that scenario playing out is slim as well. So if not Greece than who would leave the struggling union? The newest candidate to take the lead in this race is Finland.
Being a “Triple A” rated country who is fiscally responsible in the EZ at the moment puts you in elite company. However, that distinction also puts Finland in a precarious position of having to provide funding to countries that were not so fiscally responsible. Earlier this month, the Finnish Parliament tried to block the plan to use ESM funds to buy bonds on the secondary market, but under current law they are too small to block it on their own. The simple fact that the EZ may be using the AAA rating of Finland as a tool to borrow money more cheaply, but not giving Finland the ability to veto its usage may be too much for Finland to accept. Even the Finnish public is beginning to sour on their current situation. According to a recent opinion poll, 54 percent of Finns think that their country is too lenient toward more troubled European countries while only 9 percent think they are too harsh. Considering the ruling government is a loose coalition of six parties, it could break easily and lead to new elections that may sway toward the anti-European True Finns party.
In the third ring is the value of the EUR/USD. Currently hovering around 1.21, the currency pair has been touching 2-year lows for about the past month. Many factors are weighing on the currency including the ECB cutting interest rates, the issues of the other two rings of the circus, Ben Bernanke being wishy-washy about easing from the Fed, and even Germany’s Angela Merkel talking out of both sides of her mouth. Pundits the world over are bearish on the euro and are calling for a fall to the 1.18 figure at least as European politics continue to drag along slowly. Interestingly enough, a low euro may be just what the doctor ordered. A low currency value is good for exporters, tourists, as well as those who are holding debt. Therefore, a decreased value of the euro could increase exports in countries like Germany, help revive the economies of popular tourist destinations like Greece and Italy, and make debts easier to pay off in countries like Spain, Portugal, and Ireland. A lower euro seems to fix many of the ills the EZ is suffering. The trick may be in how to devalue the euro without destroying the economy, a problem that European leaders will have to figure out over the next few months.
The rest of the North American trading session will likely give rise to risk assets. The day started with a selloff, but risk has been gaining traction heading in to lunch as Dow, Oil, EUR, GBP, AUD, NZD, and CAD are all off their lows and climbing.
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