Irish Crisis Domino Effect Concerns Increase Risk Aversion

The Greenback's notable strength last week against the other major currencies was due in large part to the European financial crisis that was dealt yet another blow by the most recent Irish bailout request from the IMF and European Union.

Nevertheless, the financial markets cannot seem to stop themselves from worrying about yet another potential financial crisis, with the focus now shifting toward either Portugal or Spain to be the next financially troubled European country humbled into accepting bailout money.

Nevertheless, each successive bailout seems harder to get the approval of the more fiscally responsible Germans, who seem to feel that the bond holders should pay the price for buying high yield debt from the more financially troubled EU members.

Irish Financial Crisis Prompts Risk Aversion

The financial troubles in Europe added substantially to the U.S. Dollar's dramatic rise last week. The concerns initially solidified with the Irish financial crisis and then started spreading into worries over the financial situation of other European member states like Spain and Portugal.

The financial crisis in Ireland began causing concerns the previous week when a London clearing house - LCH.Clearnet - raised margins on Irish bonds to between 15 and 30 percent. By the end of the week, the Irish government had agreed to a joint EU/IMF bailout program, which is currently estimated to be between 80 and 100 Billion Euros.

Last Monday, Moody's Investor Services warned the markets that it might have to make a multiple notch downgrade for Irish debt. The rating agency noted that the rescue package from the EU and the IMF would, "crystallize more bank-contingent liabilities on the government balance sheet, and increase the Irish sovereign's debt burden."

The currency market basically interpreted this as a signal to buy U.S. Dollars against the other major currencies, especially other European currencies. As a result, the Euro declined by -3.3 percent last week, while the British Pounds lost -2.5 percent on the week.

The commodity currencies were also lower, with the New Zealand Dollar dropping a whopping -3.6 percent, while the Australian Dollar shed -2.2 percent. The Canadian Dollar - last week's best performer against the Greenback - dropped a mere -0.2 percent and was least affected by the financial crisis in Europe.

Domino Effect May See Portugal and Spain Next in Line

In addition to the Irish financial crisis, concerns arose over the financial position of other troubled members of the European Union such as Portugal - who is rumored to be the next troubled economy in line for a rescue package from the EU and IMF.

Earlier in the week, Portuguese Prime Minister José Sócrates stated that

"Portugal doesn't need anyone's help and will solve its own problems."

Sócrates also stated that Portugal had a clear strategy to bring down its massive deficit and that the Irish rescue had "no connection" to the situation in Portugal.

Spain was also mentioned as a bailout candidate, but it managed to sell 3.26B Euros in Treasury bills last week, although this was on the lower end of the estimated 3-4B Euros that the debt auction was expected to raise.

In Spain, Spanish Finance Minister Elena Salgado stated that,

"Spain is doing everything it has promised to do, with tangible results"

When asked whether Spain would need a bailout from the European Union, Salgado answered, "Absolutely not".

Despite the relatively optimistic comments made by Salgado and Socrates, Portuguese bonds surged last week to 6.9 percent. This pretty much mirrored the sharp yield rise that Greek and Irish bonds demonstrated just before going to the EU to request a bailout.

In addition, the spread between 10 year Spanish bonds and German Bunds hit a post EMU record of 233 basis points over the Bunds, achieving a yield of 4.87 percent on the Spanish bonds.

Nevertheless, according to some analysts, Spain is too big to bail out. They argue that the size of any meaningful rescue package for Spain is likely to use up all of the available EU funds.

Such a situation could seriously destabilize the European Union during this crisis period since Germany seems increasingly less supportive when it comes to bailing out less fiscally responsible EU countries.

Irish Bailout Fails To Support Euro As EUR/USD Moves Lower

It was formally announced over the weekend that Ireland has received a bailout package worth 85 million euros from the European Central Bank, International Monetary Fund, England, and Sweden.  Furthermore, accompanying the announcement of the bailout was a formal announcement that senior bond holders would not have to bear the financial burden of any future EuroZone bailouts.

This news was expected to be quite positive for the Euro-area, and specifically for the 16-bloc currency, but trading activity on Monday is proving that market participants are still gravely concerned about the EuroZone situation.  Over the last few weeks, mounting concerns surrounding a possible collapse of Ireland's fragile banking sector has sent the euro and Irish bond yields into a death spiral.  The EUR/USD has collapsed over 700 pips in the month of November, and Irish bond yields are at all-time HI's, as yield spreads between Irish and German bonds increase daily.

Recently, Angela Merkel, Chancellor of Germany, came out and proposed that bondholders begin sharing in the financial burden of bailing out EuroZone countries in the future.  When Greece was bailed out, German taxpayers were stuck with footing a large portion of the bill, and this has caused significant political tension within Germany.  Of course, now private German citizen wants his or her hard-earned tax money to be used to finance the wayward spending habits of irresponsible countries, and Merkel and other German leaders have been feeling this pressure from inside their country.  This proposal was met with great resistance in the investment community.  Traders responded by selling the euro.

In fact, some economists and analysts believe that Merkel's proposal served as a strong tipping point that helped drive Irish bond yields up to all-time HI's and essentially forced Ireland to ask for a bailout package, even though it adamantly refused a bailout during the first few weeks of trouble.

Thus, this weekend's announcement that Merkel's proposal would not move forward and that Ireland had received 85 billion euros in aid was expected to support the euro significantly, but traders are continuing to sell EUR/USD aggressively in Monday trading.  Currently, EUR/USD is sitting at 1.3148 just before the New York session begins trading.

Ireland Vs. Greece

When Greece faced the very real threat of sovereign default last Spring, the market sold euros like mad as EUR/USD fell from a HI above 1.5000 down to a low of 1.1875 in a matter of 6 months.  When the European Central Bank finally bailed Greece out in May, however, the market quickly reversed course and EUR/USD found strong support.  Concurrently, Greek bond yields fell sharply lower as investors became reassured there would be no default in the near-term.  The EUR/USD bottomed out at 1.1875, and then began an impressive rally up to 1.4200 over the course of 5 months.

The response surrounding Ireland's bailout has been quite different, however, which is quite interesting.  The fact that EUR/USD continues to fall in the face of the Irish bailout is a very bad sign for the EuroZone.  Furthermore, Irish bond yields have moved lower today, which means there is increased investor confidence in Ireland, but bond yields are continuing to edge higher in other peripheral nations such as Portugal.  Portugal has long been the talk of traders and economists as the next most likely target of the sovereign default epidemic in the EuroZone.

Portugal Could Be Next?

Portugal has largely been a non-competitive economy for the last ten years, as the country has grown at an annual rate of only about 1%.  Thus, since the Greek Debt Crisis, traders and economists have been saying it would only be a matter of time before Portugal suffered the same fate.  Now that Ireland has officially been bailed out, attention seems to be turning to Portugal.  On Monday morning, Portuguese bond yields continued to inch higher.  This is quite a destabilizing sign for the EuroZone.  The fact that investors are so quickly turning their attention to Portugal is a bit disheartening for EuroZone leaders.

Equity markets are also struggling to gain any momentum in the direct aftermath of the Irish bailout, as the FTSE 100 is down 0.70%, and DAX is down 0.80%, and the CAC is down 1.17%.  The fact that European equity markets are down sharply, the EURO is still being sold off, and Portuguese bond yields are rising higher all adds up to tell us that troubles are far from over in the EuroZone.

The most significant risk event of the week will most likely occur on December 1st, which is the next Portuguese bond auction.  That auction should give investors a pretty good idea how the market is going to immediately respond to Portugal.  If there is weak demand for Portuguese government debt and investors demand a high interest rate, then EUR/USD will most likely remain under severe pressure, and it will be confirmed that investors are now fully turning attention to Portugal.

It's All About Investors

Remember, sovereign default is largely about investor confidence.  For example, the United States has sustained huge, unsustainable mountains of debt over the last few years, but the market is not too concerned about it because of faith in the United States government and its ability to rebound economically.  Many doomsday economists believe there will be a day when investor confidence will be shaken to the point that they begin demanding higher interest rates to hold U.S. debt, and if/when this would ever happen, the U.S. could face economic disaster in the shape of Ireland and Greece.  However, those days are still far away [hopefully].  Those days are not so far away for Portugal, however.

If investors suddenly decide they are worried about Portugal and they want higher yields to hold government notes, then bond yield spreads could widen significantly in a very short amount of time, and this would put immense pressure on Portugal.  In fact, the pressure could become so much so fast, that Portugal, like Ireland, would be forced to ask for bailout funds.  If this happens in the near future, EUR/USD could see much lower levels.

Markets Take a Deep Breath Before the Irish Vote, Gold Rises

Gold was close to its nominal all-time high today, reaching as high as $1419 per ounce, as the Euro fell, and bourses oscillated during the day. The focus is on the Irish budget vote tomorrow, with markets remaining reasonably quiet in the lead-up period.

Bernanke says cheap yuan is bad for both China and U.S. More QE possible if the economy continues to underperform.

The limited bullishness in trading was a result of the focus on Ben Bernanke's comments today during interview for the CBS program "60 minutes", in which the chairman made it clear that he and his team are prepared to go further beyond the $600 billion in bond purchases and similar operations if the sluggishness of the economy persists.

On the USDCNY issue, he stated that the Chinese must allow greater flexibility for the yuan so that they do not have to adopt the same monetary stance as the Fed, and can combat inflation by pursuing their own independent stance based on domestic factors. He maintained the line adopted by Treasury Secretary Geithner that the Chinese position is untenable and harmful to the U.S., China, and their trading partners. On the whole, the currency issue appears to have been left almost entirely to the management of the Treasury Department, and Mr. Bernanke's comments do not signal any change.

The chairman was asked some questions about the external debt of the U.S., to which he replied in an optimistic but cautious tone, saying that while the U.S. does not face a confidence or solvency crisis at the moment, Americans should not "wait however many years it takes until we are at that point". He maintained his cautious tone in response to questions about budget cuts, stating that the U.S. must avoid hasty budget cuts, although something needs to be done to manage the rising debt burden.

Although in this particular case, Bernanke did much to say nothing while talking a lot, in general it is hard to fault the Fed Chairman for indecisiveness, or lack of clarity. The ECB for instance, finds it difficult to find a common stance nowadays, and is a hotbed of dissession of conflicting opinions. Rapid reversals of course are common. The Fed, on the other hand, presses on with its conclusive main theme of printing as much money as it can in order to keep the economy afloat and preventing a recession, and while the merits of its choices are always open to heated discussion, that it has been communicating its plans sufficiently clearly over the past quarters is not a major point of contention. Whether this will benefit the U.S. economy over the long term is a different matter, however.

Merkel threatens to leave the Euro, refuses to commit to an enlargement of the EFSF, CDS rally

The Guardian newspaper has published an article where it is reported that PM Angela Merkel threatened, somewhat lightly, that Germany may quit the Eurozone if her concerns are not heeded. Bloomberg, too, reports that the Germans are unwilling to join the Eurobond idea currently being discussed, and that they don't want to sponsor the proposed increase in the size of the EFSF. At the same time, the same Germans are saying that the Euro is safe, that the Eurozone will not break up, and that they will do their utmost to prevent the risks from threatening the demise of the common market. One must wonder what exactly they have in mind if they are not prepared to pay when the bill comes due, since the cost of the survival of the single currency is not small.

There seems to a degree of consensus among a majority of analysts and commentators that the Germans will eventually have to give in to market demands, if only because the alternative is impractically dangerous and destructive. No one knows how deep the impact of the chain reaction following the implosion of the Euro would be. We quote in this context briefly from report in Bloomberg that reads:

Europe has "no credibility" in ruling out debt restructurings, Kenneth Rogoff a Harvard University professor and former International Monetary Fund chief economist, said in a Bloomberg Television interview broadcast today. "Greece will be very lucky to avoid restructuring, Ireland, Portugal -- they're just in denial, saying it can't happen. They really haven't drawn clear lines, they haven't really said what they wanted to do, they haven't really made choices."

Nor can the nations of the core afford to let them collapse with totally unpredictable consequences for the whole world. So some series of bailouts will follow until Spain reaches the door with open hand.

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Meanwhile, ECB's Christian Noyer, the Governor of Bank of France, has remarked today that the present measures of liquidity are to be maintained at least until the first quarter of 2011.Many suspect that they may be extended quite a bit further unless the periphery stages a rather unlikely recovery by then.

Although Moody's cut Hungary's sovereign rating by two notches to Baa3, the debt markets were generally stable, after the exhausting widening of the past weeks. The market remains weak, but is not willing to stage any strong move to either side at the moment. This is, after all, a Monday. Our eyes will be on Ireland's vote this week on the 2011 austerity budget, as the government tries to survive with its paper-thin majority. The possibility of failure, and an ensuing general election is preventing the markets from staging a meaningful movement before the result of the Tuesday vote becomes clear.

With respect to the interbank market, the improvement in CDS and peripheral spreads has not been mirrored in the Euribor rates, with the 3-month benchmark moving to 1.028% vs. Friday's 1.027%. Euribor rates have retreated from the 1.050% level reached earlier, but we conjecture that they will reach beyond those levels at some point next year as the usual concerns become transferred to the banks due to exposure concerns. That tensions remain significant in this segment is made evident by the deposit facility usage statistics of the ECB, which show that Eurozone banks placed some Eur84.85 billion in the bank's coffers for interest income versus the previous week's Eur26.93 billion, implying a lack of counterparty trust in the region as uncertainty dominates. These numbers are tempered by the lack of a need, apparently, to resort to the marginal lending facility, which we take to mean that the banking sector remains isolated for now from the issues for as long as the authorities can avoid a breakdown. As Merkel's comments show, however, it is far from clear that this will be the case.

Monday is a quiet day, with few news providing guidance on how the rest of the week may progress. At the same time, we suspect that the Irish vote tomorrow has the potential to wreak havoc on the markets if the result leaves the country without a government during this most difficult period.

IMF Complains about Eurozone Inaction, Markets Focus on Irish Budget

A short time from now, the results of the final Irish vote on the new and severe austerity budget of Finance Minister Brian Lenihan will be made public. In all likelihood, the budget will pass, but a failure has the potential to send the entire market upside down so soon after the jump in CDS and bond rates last month. Reflecting this sentiment, the Euro has settled near the unchanged level after moving up and down for much of the day, while the USD is lower by as much as 1% after making similar movements during the day. Gold has been volatile, and after testing $1429 and breaking a new record during the day, it is down by around $5 on the day as this is being written. Stocks, however, are up across the board, with weakness limited to Japan and Asia. Europe and the U.S. are up strongly.

Today the Fed is reported to have continued the heavy bond purchases of yesterday, and today's action recorded an all-time high acceptance rate of 41.5% in two separate bond purchases worth $6.8 billion, and $16.4 billion. Apparently in response to the weak Friday NFP number, Ben Bernanke has committed his institution to a very aggressive course where the self-imposed $600 billion limit could be exceeded easily. Certainly, data releases in 2011 may show some improvement in the U.S. economy, but it is unlikely to be strong, and with the European issues in the minds of traders and consumers, we find it difficult to believe that a significant change in the growth path of the U.S. can be achieved. Most statistics earlier this year implied that the U.S. would be in a recession by now, and it is not too much to assume that the revival in activity is at least in part due to the expectations of aggressive Fed intervention in the economy and the market. As such, we suspect that as the end of the announced bond purchase period approaches, investors and consumers may begin to retrench once again, necessitating a further dose of quantitative easing by the Fed, which seems only too willing to supply as much of the favored medicine as possible, with almost no concern about the side effects. The USD, in particular, is the sufferer.

In Europe, as we mentioned, it is more of the same today, with limited directionality in the market action of the most important segments, but we note the critism of Dominique Strauss-Kahn, the IMF director who commented today that "the euro zone has to provide a comprehensive solution to this problem," after meeting Greek prime minister George Papandreou in Athens, adding that "the piecemeal approach is not a good one." His agreement with the Greeks is not a surprise, since they are on the receiving end of aid, while the IMF director's main interest is ensuring that the global financial system is spared the shock of a Euro breakup at all costs. The Germans, who appear to be the main objectors to the proposals of improved EFSF coverage, and joint bond issuance, are the ones to pay, and their position is equally understandable. They have been fleeced enough in consequence of their commitment to the European project, and that they don't appreciate any more of the sour dish is not to be blamed on the choosiness or gluttony. And yet, here lies the crux of the matter, since when all sides have meaningful, solid arguments and positions that appear difficult, if not impossible to reconcile, a deadlock has been reached, and a solution will be much more difficult to find. That is what seems to have happened in the Eurozone. To be sure, the bailout party is not over yet, since the politicians will yield once they are cornered again and forced to make a yes-or-no decision. But this cannot go on forever.

In yet other Eurozone and ECB news, we have the quaint announcement today that another round of stress tests will be conducted in February, since it has become apparent that the market does not take the July's mock-examination seriously. The problem that the ECB faces in this issue is that each time they undertake to conduct successively stricter tests, and fail to apply criteria as severe as the market would like to see, they risk creating a self-sustaining cycle whereby investors unnerved by the dishonesty of the ECB sell-off on risk, and undermine the financial status of the banks which the tests had tried to assess. And when the deterioration in the situation is so sharp that it can't be ignored anymore, the central bank moves to repeat its actions, with unsavory results. Let's hope that this time the ECB will not be as conservative in its risk assessment as it is with its monetary policy.

3-month Euribor is one bp higher today at 1.029% vs. yesterday's 1.028%. The PBOC kept the USDCNY rate near unchanged.

Today is a day of suspense and rest for the markets, and it is possible that trading will go into a weaker tone as the end of the year approaches. One must not underestimate the possibility of a Euro rally, however, since many traders will prefer to close positions heading into this period in order to cash out on profits, reassess strategies, and for bookkeeping purposes. All that could lead to a Euro rally, but we don't think that the 2011 outlook for the currency is bright given the large number of open questions that await their answers. The Fed may be determined to supply as much cash to the market as it needs in order to fulfill the narrowminded goals that it has defined for itself, but Eurozone problems, and the future of China remain the key issues nonetheless, and may easily undo or make irrelevant whatever choices the Bernanke team may take.

Fitch Cuts Irish Credit Rating to BBB+

The main theme of today is the ratings downgrade of Ireland, but markets still performed reasonably well on the day, with Asian and European boursesup, while U.S. markets demonstrate a lack of momentum. The main spots of weakness were India and China, with market mood dampened in the latter by concerns about rising interest rates, and in the former by the recent bout of corruption scandals that have shaken the government of PM Manmohan Singh. Against this background, the EURUSD barely moved, while the USD was little changed against its major peers. The USDJPY pair is  testing its 100-day MA, with little followup so far. Among commodities, after failling to make much downward progress during this week, gold started the day in the red, but seems likely to end it in the black.

Fitch downgrades Ireland`s credit rating to BBB+

Today Fitch cut Ireland`s sovereign credit rating by three notches to BBB+, to two levels above speculative grade, in a move that was widely anticipated by the markets. We think that BBB+ is too high for the country, given the uncertainties that surround its financial independence, but Fitch is still the most realistic among the three major credit rating agencies.

The CDS market is reported to be pricing in losses of about 20% for senior holders of Irish debt due for the next 3-5 years, and Fitch`s move has not had a perceptible impact on the bond or CDS markets, as it does not go much beyond the certification of the obvious. Still, West European sovereign CDS generally ended the day with a higher yield today.

3-month Euribor was unchanged today at 1.029%. USD Libors show little movement. In other Eurozone news, German HICP inflation has continued to trend higher, with the latest number coming at 1.5% y-y vs. the previous 1.3%. It is unlikely that the Eurozone inflation will become a serious problem next year, but if the trend continues, as it is possible it will do with the Euro depreciating, the ECB will find it even harder to engage in further easing while maintaining any remaining degree of credibility.

BoK leaves interest rates unchanged

The Bank of Korea is reported to have left interest rates unchanged after moving to increase them last month in response to rising inflation. Nonetheless, the pressure to keep the won weak is strong, and the bank is not likely to change the current stance for some time to come. Korea`s recovery has not been very robust, and low rates make sense from more than one angle.

In the rest of Asia, we have yet more evidence that Asians are committed to reining in speculative inflows in a decision by China`s SAFE to the effect that the interbank FX market will close at 4:30 pm (8:30 GMT) from next Monday, revising the existing regulations that ends operations at 5:30 pm. In a similar move, they are reported to have advised HK not to drop the peg, since, we think, that would accelerate the fall of the USD and greatly complicate their management of the yuan.The Chinese are obviously unnerved by the massive amount of speculative cash flooding the country, and hope to be able to limit the impact on the domestic market through cosmetic measures such as this latest announcement, but as long as appreciation expectations remain, there is very little that they can do to reverse the trend, especially because there are few alternatives in today`s world against the safe bets provided by the USDCNY pair.

We conclude by noting the announcement by Goldman Sachs today that it is revising downward its previous EURUSD forecasts for the next year, in  acknowledgement that they have been over-optimistic in assessing the performance of the Eurozone, and the troubles of the periphery.  The bank is still bullish, however, with a 6-month target of 1.45 vs. previous 1.50, and a 12-month target of 1.50 vs. a previous 1.55.