IS EMU Debt Crisis Morphing into a Euro Positive Force?

We argue that a key driver lifting the euro has been the divergent monetary policies of the Federal Reserve and the ECB. When investors perceive the European debt crisis becoming acute, it has eclipsed the main driver and weighed on the euro episodically in recent months. However, the increased speculation (and therefore risk) that Greece restructures its debt may be transforming the debt crisis into a more immediately euro positive direction.

There have been a couple of developments that spur this line of thinking. First, although Greek bonds are stabilizing today, the sharp sell-off over the past few weeks, is as much cause as effect of the restructuring speculation. European official comments do not rule it out as they once did or are not ruling it out with the same vehemence.

Second, banks are gradually reducing their reliance on the ECB. This week, European banks had to return more than 71 bln euros they had borrowed for the past three months and replaced it with new 3-month borrowing of "only" 63.4 bln. The market had anticipated an increase in borrowings, not a decline.

Here is the forensic case: a) banks are relying less on the ECB, b) risk of Greek default has increased, c) European banks are securing their euro funding for this possibility/probability/eventuality.

Third, the rise of the EONIA, the key overnight rate in the euro zone, has been very pronounced and seems to reflect this scramble funds. The ECB met and hiked rates on April 7. EONIA closed the following day at 54 bp. By the end of last week it was 143 bp. Some of this may have been due to the holiday weekend and it has slipped back to about 128 bp yesterday. There may also be some month end pressure, but even when these allowances are made, EONIA seems to be elevated and reflecting greater demand for euro funding.

Fourth and as additional supportive evidence, recall that the ECB was unable to fully sterilize its stock of sovereign bond purchases earlier this week. Part of the reason is that it may have been unable to do so is that market rates (EONIA) were higher than what the ECB was offering.

To be sure, the divergent monetary policies between the Fed and the ECB, driven home by FOMC statement and Bernanke's comments yesterday and the stronger than expected German employment and PPI report today, remains the key force lifting the euro. We have argued that provided the European debt crisis remains confined to Greece, Ireland and Portugal, and the spillover to Spain is minor, the divergent monetary policy stances will remain the main driver. Here we explore a force that might explain why the risk of a Greek restructuring could help explain the rise EONIA and may be supportive of the euro