Europe faces the wall
In previous comments we often underlined that debt markets were far more pessimistic than equities or EURUSD. In turned out that those investors were right. Yesterday a yield on Italian 10Y bonds skyrocketed above 7% after the largest clearing house in Europe raised collateral requirements for positions in those instruments. While that was the trigger there is also a deep underlying fundamental problem.
On Monday we pointed at the fact that Italy might already be in a recession. That fact alone means that the general government deficit in the near to medium term will widen rather than narrow (as assumed by the Italian government). Higher financing cost add to this burden and those two factors combined create an additional deficit even after subtracting promised savings. Italy can hardly save much more in the short term without dragging the economy into a deep deflationary recession. Therefore the only viable choice is to convince the markets with deep (and politically painful) structural reforms… with an external support.
Italy would need at least 650 bln EUR not to tap the markets for the next three years and Europe probably cannot afford that. Therefore other solutions must be considered, including:
- Aggressive purchases of Italian debt or even direct sponsoring through the ECB
- IMF sponsored bailout program with IMF obtaining funds from BRICs and perhaps US
In both cases it would take tough economic reforms over sought by the IMF. The trick is that there must me a credible government in Italy to negotiate such solution. The Greek case (there is still no new PM even though one was supposed to be announced on Sunday!) shows that creation of a national unity government might not be straightforward even under dire circumstances. Italy has some comfort with significant bond redemptions in Feb-Apr’12 and some cash cushion. But that might not be a good news for the markets as there might be no rush to take tough decisions.
A reaction on the EURUSD was significant but not excessive. We illustrated a downward potential stemming from both interest rate and credit markets on the charts in previous snapshots and the pair only realized part of it. The move also fits well into technical frames. The pair was in a one-week consolidation which took a form of a flag after significant declines from 1,42 to 1,36 at the beginning of November. A flag is typically a continuation pattern and so it was this time. A minimum range of 1,35 has been already reached and further supports are at 1,3380 and 1,3230. This final level would be more less consistent with what the interest rate picture is telling us atm.
Italy will try to sell 5 bln EUR of 1Y bills today. However, a real test will come with an auction of 5Ys on Monday. Europe ain’t got a lot of time to sort things out.
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Przemysław Kwiecień PhD, Chief Economist |
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