EUR: Damage Control In Spain And Italy Begins

Includes: ERO, FXE
by: Kathy Lien

The euro ended the North American trading session only slightly lower against the U.S. dollar following an intra-day recovery that lifted the EUR/USD off its fresh 2.5 year low of 1.2068. The currency pair was sold aggressively during the first half of the European session, as investors grew more concerned about the need for a Spanish sovereign bailout. Over the weekend, El Pais, the most widely read newspaper in Spain, reported that Catalonia, the second-most populous region in the country could join Valencia, in seeking financial help from the central government. The region of Catalonia is the largest contributor to Spanish GDP because Barcelona is one of its provinces. The paper reports that four other regions could also seek aid if this speculation by El Pais turns into reality, in which case Spain will not be able to avoid a sovereign bailout. With 10-year Spanish bond yields climbing to a record high well above 7% and speculation brewing, Spanish officials are focusing on damage control with Economy Minister De Guindos denying that Spain needs to be rescued by the European Union. Of course we have heard these same denials before by Greece and other European nations that have been forced to ask for a bailout.

One form of damage control however seems to have worked. Spanish and Italian stocks have been on a downtrend since the beginning of the second quarter but over the past month, Spanish stocks have fallen 13% while Italian stocks have dropped more than 11%. The sharp slide in equities coupled with the jump in Spanish and Italian bond yields forced policymakers to spring into action. We've seen the first damage control from market regulators. Italy banned short selling of financial stocks, effective immediately until July 27, while Spain decided to be even more aggressive by banning short selling on all stocks for the next three months. These announcements triggered a major turnaround in Spanish and Italian equities and the EUR/USD. Yet the IBEX (Spain's stock market) still ended the day down 1.1% while the FTSE MIB (Italy's stock market index) closed down 2.76%. The market's focus is on Spain but concerns about Italy are growing. Last week, Prime Minister Mario Monti expressed serious concerns about the possibility of default by Sicily, which accounts for 5.5% of Italian GDP. Today, Italian regional authorities warned that they may not be able to open schools after the summer break if spending cuts go through. While we doubt that Monti would sacrifice the education of Italy's youths, this warning nonetheless highlights the gravity of the nation's fiscal finance problems.

While the ban on short selling helped to stem the losses in currencies and European equities, if stocks resume their slide and bond yields in Europe continue to rise, an emergency summit may have to be called to deal with the market turmoil. Otherwise, it will be a problem that the European Central Bank will have to address alone when they meet on August 2. Eurozone PMI numbers are due for release tomorrow. Economists are looking for manufacturing and service sector activity to hold steady in July. Any downside surprises could trigger further weakness in the EUR/USD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.