Still Want to Fade Euro Bounce

Events in Athens are dominating the focus in the foreign exchange market. After yesterday’s blowout following the Eurostat report finding that last year’s deficit was even larger Greece (and Ireland) than previously reported and the Moody’s downgrade of Greek debt, initiating the emergency backstop facility appears to have become inevitable. Reports indicate there has indeed been a formal request by Greece to do so.

Initially in Asia, the euro fell to almost $1.3200 and speculation that Greece would use the funding mechanism saw a powerful recovery in the euro. The issue now is whether it is too late and what was once seen as a liquidity crisis has morphed into a solvency problem.

We have several concerns. First, the size of the facility is sufficient to covers this year’s remaining needs and part of next year’s. This would suggest that Greece may still try to raise funds when market conditions allow for it. However, a multi-year program is likely necessary and European officials seem to have to be dragged kicking and screaming into this recognition.

Second, officials seem to be stuck in a reactive mode and have not been able to get ahead of the curve. Specifically as recently as yesterday, IMF head Strauss-Kahn ruled out a preemptive package for Portugal and/or Spain, arguing there was no need. Hence we are still concerned about contagion.

Third, we remain concerned that the underlying issue of competitiveness in the periphery of Europe is not really being discussed as the focus is largely on Greece’s ability to service its debt. One of the consequences of the fiscal austerity that is being mandated is that it will keep aggregate demand suppressed and could then still produce a widening of the output gap in Europe.

Therefore on balance, we would be inclined to fade the euro rally. For the better part of the past six months, European officials have disappointed investors by not delivering satisfactory closure and we suspect the risk is for more of the same. Looking at specific levels for the euro, we note initial resistance near $1.3350. A move above there would likely be checked in the $1.3400 and then $1.3450 area. On the downside now, a move back to $1.3250 is possible on any disappointment. Over the medium term, the issues outlined here, within the context of an expanding US economy (~3%) will likely push the euro back below $1.30 with a move toward the mid-$1.20s a reasonable target.

While Greece is the dominant factor today, it is not the only development. The UK is the first G7 country to report preliminary Q1 GDP figures. They were disappointing. The consensus expected a 0.4% expansion and instead ONS said the economy expanded half as much. The 0.2% rise was also half the pace reported in Q4 009. Nevertheless, because of the base effect, the year—over-year contract eased to -0.3% from -3.1% in Q4 09. The economic trough was hit in Q2 at almost -6.0%. The preliminary report indicated that services expanded 0.2%, while industry expanded by 0.7%.

After apparently losing the first two debates, Prime Minister Brown is likely to come under even more pressure in the weekend press. There is much talk that even if Labour wins a small plurality of votes, that as a condition of a coalition government the Lib-Dems may rule out Brown as Prime Minister. There is also talk that Lib-Dems Cable could be a likely candidate for Chancellor of the Exchequer. We will have an extended discussion in a SpecialFX piece next week. For now support in sterling is seen in front of $1.5300 and a cap near $1.55.

After what appears to have been a slow start to the year, after a near stagnant Q4 09, the German economy appears to have picked up momentum as first quarter progressed. This has been the message of the recent string of economy data and was driven home by today’s stronger than expected IFO survey. The business climate reading came in at 101.6 (98.2 last), the highest since May 2008. The assessment of current conditions and expectations also rose. The weakness in the euro may also be helping sentiment as Germany exports around 40% of GDP (roughly the same as China). Separately, the euro zone reported a 1.5% rise in Feb industrial orders, well above expectations and largely offsets the 1.6% decline in Jan.