Spain: No Mas

The accusations of corruption against senior Popular Party officials, including Spanish Prime Minister Rajoy would not have necessarily been a market mover.   The accusations raise more questions than they answer.  However, Rajoy's denial may have deterred Asian traders early Monday, but European investors were more skeptical.  

Confidence in the Rajoy government has been eroding as the economy deteriorates.  The fourth quarter contraction was deeper than the Bank of Spain expected.  News on Monday included the largest jump in unemployment since January 2013.   In addition, Spain's three largest banks, Santander, BBVA and CaixaBank announced large write downs in recent days, in part due to large real estate provisions, reminding investors a key source of Spain's vulnerability.

Calls for Rajoy's resignation from opposition forces were given more credence by the financial press than they deserve.  Nevertheless, the political fragility is palpable.  The one thing that could bolster the government's support is not German Chancellor Merkel's best wishes, but an substantial improvement in the Spanish economy.  This does not look to be forthcoming for at least several months.   

The decline in sovereign yields over the past six months has been a powerful tonic.  Spanish financial institutions are large holders of government bonds.  Their access to the capital markets also improved.  This is part of the positive contagion.  

Spanish bonds sold off sharply on Monday.  It seemed to trigger a slide in the euro after new multi-month highs were set before the weekend above $1.37.  The last part of the euro's rally took place even as Spanish yields were rising in absolute terms and relative to Germany.  

The Spanish-German 2-year spread bottomed on Jan 11 near 200 bp.  It finished last month at 230 bp and is now just above 260 bp.  The Spain's 2-year yield bottomed on Jan 10 at about 2.11% and had risen to 2.50% by the end of Jan and was near 2.88% on Monday.   

A similar story is told by the performance of the 10-year bonds.  Spanish 10-year bond yields have been rising and driving the premium over Germany has been rising for a few weeks.   Spain's premium fell to 330 bp on Jan 11 and has been trending higher since.  The premium stood at 355 bp at the end of Jan and 382 bp on Monday.   The Spanish 10-year yield bottomed the same day just below 4.90% and is now at 5.43%

The review of the recent action illustrates that the euro has been able to rally in the face of the increase in Spanish bond yields and widening premium over Germany.    The key question now is whether this phase is over and the risk emanating from the periphery will again be a driver of the foreign exchange market and the capital markets more broadly.    

It is coming too amid increased political fallout of the third bailout of Italy's third largest bank, Monte Dei Paschi.   The center-left PD has suffered the most in the polls three weeks ahead of the election.  Although it is still ahead, the margin over Berlusconi's PDL has narrowed.  Berlusconi, the consummate politician is running circles around this rivals, appealing the basest populist instincts.

As an aggregator of information, the market generates noise and a signal.  We suspect the flare up in political tensions is noise and that the underlying signal generated by the OMT backstop (which is the inducement cited by some of the world's largest money managers for returning to the European debt market) and the more recent passive tightening of monetary conditions in Europe will continue to underpin the euro.  

The latter is taking place at the same time the Federal Reserve renewed its commitment to buying $85 bln a month in long-term assets.  Although US job creation has accelerated, the economy is downshifting.  Over the past four quarters, the economy has posted average annualized growth of 1.6%.  Over the past three year, quarterly average has been 2.0%.  Moreover, the impact of the end of the payroll savings tax holiday and the sequester warns of a couple more quarters of weak growth.

We anticipate that new euro buying will emerge on this pullback. Investors may rightfully be cautious ahead of the ECB meeting.   Sharp sell-offs, like the one seen Monday, are rarely a one-day phenomenon.   Technically, there seems to be scope for euro losses toward $1.34.