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Euro Weekly Outlook: Death By PIIGS Uncertainty

 The ECB Needs a "Plan B" For The PIIGS 



Euro Outlook: Bearish

-    Events: TUES: German Retail Sales, WED: Retail Sales, THURS: German Factory Orders, ECB Rate, Press Conference

-    Greek debt sales show little confidence in the country’s and the Euro Zone’s future

-    Portugal budget also generates little assurance of meaningful improvement in its credit rating, builds concern on Euro stability, or possibility of bailouts devaluating the Euro

-    Lack of clear plan for dealing with PIIGS creating uncertainty that corrodes the Euro's credibility. Helpful for short term devaluation, but risks long term trouble

-    German business confidence hits an 18-month high

-    Did EURUSD find a medium-term top in January?


The euro has fallen to its lowest levels since July as declines take hold for the fifth straight day. While US Dollar weakness boosted the Euro through much of 2009, dollar strength is now pummeling the Euro lower.  This is not surprising, given that the EUR/USD pair alone comprises 33% of all forex trade, thus these two force each other to move in opposite directions like children on a seesaw. Looking for significant threats on and off the economic docket, there is plenty to keep track of. But the greatest risk to calm markets likely comes from unexpected indicators and unpredictable events, particularly from Euro-zone sovereign debt troubles, which have been undermining confidence in the Euro since December, and are as much a reason as any for the shift in the EUR/USD's fortunes and trend.

There are many reasons to doubt the strength of the Euro Zone and its currency; but the most politicized and media-hyped peril is Greece’s burgeoning budget deficit.  While Greece has assured us that it will do what is necessary, few seem to believe them. The discovery of badly understated deficits over the past years has not helped Greece's credibility.

The Euro Down Trend: Slow Death by Uncertainty?


The EU has repeatedly warned Greek that it was not doing enough to meet its goals to bring its deficit back within the limit within their time frame. Perhaps more disconcerting is the suggestion by EU Economic and Monetary Affairs Commissioner Almunia that there is no “plan B” for Greece and that “in the euro area, default does not exist.” If the economy cannot meet the group’s strict rules and the nation’s neighbors do not provide assistance, something will have to give.

If rumors are correct, that most likely means a bailout (that spreads the pain), but that could fail, and lead to a defection from the euro (which throws the stability of the currency into immediate doubt); either way, the outlook for the currency is not bright, for Greece is really just a test case for how the EU will deal with its other fiscal problem children: Ireland, Spain, Portugal, Italy, Latvia, etc. It's virtually assured that EZ policy makers will be facing the same situation with at least one of these.

For example, this past Tuesday, Portugal reported a larger budget deficit of 9.3% of GDP last year (the EC had expected something closer to 8%), but promised to reduce the deficit to 8.3% this year and back to the mandated 3% level in 2013. Judging from the developments in the debt market today, including the sovereign CDS markets, many doubt measures are sufficient. The debt to GDP ratio is set to continue to deteriorate. It is expected to surpass 85% this year and may be the highest in 20 years from about 76.6% last year.

However, here's the problem: even if Portugal can reduce its deficit to 3% of GDP as the Stability and Growth Pact mandates, it will still not be able to stabilize its debt to GDP ratio because growth is so anemic. The last quarter that Portugal posted year-over-year growth in excess of 3% was Q2 2001.

The fiscal headwind suggested by a 6 percentage point cut in the deficit in 3-years will likely mean slower growth rather than more. Moreover, as noted about Greece, so too with Portugal: efforts to reduce the structural deficit serves cut growth, which in turn creates a vicious spiral of more spending cuts needed, causing less growth, etc. We won't even discuss the social unrest likely to follow or political feasibility of carrying out continued spending cuts.

The ECB Needs A Contingency Plan

As with Greece, Portugal's recovery is extremely fragile under the best case scenario. Any deterioration of growth, or significant increase in interest rates, risks another downgrade for  Portugal's credit rating, already on negative watch. That would further complicate whatever recovery hopes remain. The picture is similar for Spain and Europe's most troubled economies. Moreover, while Greece and Portugal represent only 3% of EU GDP each, Spain's contribution is closer to 20%, as is Italy's. Thus it's especially important that a 'plan B' indeed be clarified as quickly as possible in order to buttress the Euro's death by uncertainty.

Thus, unless the ECB is willing to risk a convenient major decline in the Euro metastasize into a failure of credibility in the Euro itself, it needs to calm markets by showing it has a plan for dealing with countries that are unable to meet credit rating standards mandated by the Maastricht Conventions for the  beginning of next year.


The major event risk this week emanates from the US in the events leading up to and climaxing in this Friday's Non-farms payroll and Unemployment reports. Both the US dollar, the Euro, and most other asset markets will be heavily influenced by changing expectations about the Friday reports that earlier US data will generate.

The ECB rate decision is top EZ event risk. However, there is a very low probability that the market will be able to draw enough from the event to alter the time table for an eventual return of rate hikes. Fundamentally, there is little motivation for near-term rate hike. Inflation pressures are muted, the economic outlook is tepid, unemployment is at best trending up to fewer job losses or minor gains like the US, and policy officials realize that raising rates too early can turn a difficult recovery for many members into an impossible one. 

While rates are unlikely to change, the main thing to watch out for will be plans for a further unwinding of extraordinary policy measures and comments on the recent slide in the euro. A weaker currency helps to support growth and therefore we don't expect ECB President Trichet to say much to stem the currency’s slide, though again, he needs to show the world he has plan for dealing with the PIIGS. Meanwhile, EUR/CHF  surged 100 pips very quickly on an intraday basis, raising concern about whether the Swiss National Bank has intervened in the currency. The central bank has failed to comment but based upon the magnitude of the move that we have seen after prior interventions (Up 400 pips within minutes in March), the move today smells like intervention but at best was just an initial warning move attempting to scare off buyers.

Disclosure: No positions