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More on the Euro and Systemic Risk

The ongoing political dance surrounding the timeframe and means of Greek debt restructuring will ensure that systemic risk remains a strong influence on the euro. The market’s self-defence mechanisms have kicked in with investors pricing down the chances of ECB rate hikes over the next year to 90bps, compared to 150bps a month ago.

Fears about Greek debt restructuring and Spain contagion concerns have also caught the market short of hedges and encouraged a flight out of peripheral Euro zone government debt and into safe-haven Bund holdings. This has shaved over 20bps off the Euro zone’s Bund 10yr benchmark yields in the past week. As a result, the Greek contagion effect has diminished both the euro’s cyclical and structural yield advantage along the yield curve (see charts at the end).
In the short term, the ability of euro markets to look through the EU political risk surrounding costly bailouts will be determined by two major factors. First, the fundamental implications of the solvency crisis, and second the EU’s efforts to manage and contain the costs.  

Fundamental and Financial Trends Decouple But for How Long?

On the first point, Europe has so far managed to engineer a remarkable combination of an economic expansion versus a financial imposition. Today’s April Euro zone PMIs and February ECB balance of payments economic reports showed that the Euro area's "core" countries, Germany and France, are expanding at the fastest pace since 2007, before the subprime pre-crisis, and regional capital markets can attract foreign capital on corporate bond valuations and money market relative yield models, so long as the PIG (Portugal, Ireland, Greece) crisis remains contained. The figures suggest that, for the Euro zone's balance sheet in aggregate, sovereign stresses are concentrated in the financial rather than the real economies.

This, however, contrasts with the ongoing implosion occurring in financial balance sheets. A timely reminder of that came in with the weekly ECB unlimited allotment MRO this morning. European banks bid €97.4bn of liquidity from the ECB, which – after taking into account banks’ structural reserves needs – has diminished the surplus of “excess liquidity” in the system to just €13bn, compared with €18bn last week. If one assumes that about half of that is deposited back at the ECB (this morning’s ECB data showed that banks actually deposited €9.5bn overnight), this leaves daily working capital in the system of just €6bn or less.  Far from a process of normalization, the implosion of interbank funding markets points to the banking system’s shrinking capacity to accommodate risk. This may be what European monetary authorities would like to see, but it is far from a pro-cyclical strategy. A forced deleveraging caused by Greek debt restructuring is bound to wipe off at least another €100bn off banks’ working capital, and that is assuming that EU capital guarantees and injections are employed to ring-fence Spain and systemically important institutions. This is bound to have some broader capital market implications down the line. European corporates may have successfully disintermediated from risk-averse domestic lenders through global primary markets, but it is doubtful that this will remain the case if overseas investors begin to lose confidence in the financial arm of Europe’s Monetary Union.

Political Headwinds Ahead

Against this backdrop, EU denials of the possibility of a Greek credit event show that fear of another banking crisis and a broader capital markets fallout remains the driving principle of the EU's management of the crisis. The EU's defensive approach, alongside resilient economic reports, have produced some tentative calm in euro market conditions today following the recent turmoil.

Yet, the market's process of EU solvency risk re-pricing is set to come into some significant political headwinds over the coming months. Finland, where the True Finns party enjoyed resounding success at the weekend's parliamentary elections, will have to have its say on Portugal’s bailout by the middle of May. Anti-bailout voices are also getting louder elsewhere, notably in Slovakia and Netherlands. None of these countries are major contributors to EU bailout funds but their voice is significant given the EU requirement for unanimity and the EC will be hard-pressed to push through bailouts if they are seen to be undemocratic. The IMF and the EC are expected to review Greece’s finances in a report in June, which is bound to bring the issue of the government's insolvent position back to the fore. And there is still a big question mark over financial systemic risk and how European governments agree to act on this front after the European stress tests results at the end of June.  

There is also the danger of bilateral action from Greece, and the risk that this is followed by Portugal. Greece’s official rhetoric so far suggests that the government is prepared to continue to align with the EU and accept the IMF’s austerity funding program in order to avoid a “chain reaction” of contagion across the EU. Yet, the Greek government can justifiably argue that, in spite of the EC and IMF involvement, with its 2yr yields close to 20%, Greece will have to default and restructure in order to be able to return to capital markets in 2012 or beyond.

In summary, in spite of official denials and the ECB’s hawkish stance, fears that the Euro zone’s banking system will sooner or later have to suffer the collateral damage of Greek debt restructuring, as well as a broader capital markets shock, are likely to weigh on the euro, pushing the 1.45-50 mark beyond reach and opening the way to the mid-1.30s by Q3.