Spanish Bailout Talk Heats Up

Good day, and welcome to another Terrific Tuesday. Yesterday was pretty much a blur for me, as it felt like that I had just unpacked everything in the morning and then it was time to unplug the laptop and head home for the evening. While Mondays are always busy, it just seemed like time moved faster than normal for some reason. If we throw in the fact that the same handful of news stories appeared to be on a continuous loop, there wasn’t much to break the monotony and provide definition throughout the day.

So the question then becomes who forgot to press the play button? Monday could be summed up in one word, which is the euro (EUR). I could very easily say the European debt problems ruled the roost yesterday and head into the currency roundup, which wouldn’t be very productive, but it was just a continuation of what I talked about yesterday. We even saw similarity in the fact that the early-morning trading session brought the lows of the day and set the tone before the stock jockeys were able to finish their morning cup of coffee.

I guess there’s no sense in beating around the bush, so let’s take a closer look and see what we can find that lit a fire under the you-know-what of the dollar bull crowd. Let’s start with Spain. Investors are becoming more and more concerned that Spain will need a formal bailout sooner, rather than later, since chatter among several Spanish regions asking for a bailout from the Bank of Spain is getting louder. Valencia was the first to arrive at the party, as they knocked on the bailout door and it’s reported that six other Spanish regions could seek aid in order to finance deficits and other daily operations.

The general market consensus right now is that if these different regions or cities all show up with their hands out, then a true sovereign bailout of Spain is right around the corner, so this scenario is looking more and more likely. Investors are already pricing this event into the market on two fronts. The first is, obviously, the currency, as the euro fell into the 1.20 handle and represented the weakest levels since June 2010. In fact, the euro fell to as low as 1.2067, which is below the average price of 1.2087 since its inception. If this keeps up, it won’t be long before we start testing the recent low of a couple years ago at 1.1877, which at that point was the lowest level since January 2006.

The other place we saw negative investor sentiment came in the Spanish bond market as the 10-year yield climbed as high as 7.58% at one point, which marked the highest figure since November 1996 and by far the highest in the euro era. As we saw with the other euro nations that did receive a full bailout, the 7% area designates a line in the sand for unsustainability. In fact, I saw a report that stated even if these other Spanish regions didn’t ask for a bailout, it would take only a couple of months with yields this high to force the hand and leave no alternative but a bailout.

The bottom line is that Spain firmly remains on the hot seat, and the fourth round of austerity measures this year that were announced last week pretty much rules out the notion for a domestic recovery anytime in the foreseeable future. Government officials are doing their best to keep the wolves at bay, but the planned budget cuts through 2014 amount to roughly 10% of GDP. Some of these measures include an increase in sales taxes, the elimination of tax rebates for home buyers and a reduction in unemployment benefits. If we look at the big picture, it almost seems like an inevitable event and the markets have all but lost faith. After looking at all of that, I couldn’t help but bring a parallel to the U.S. if things don’t turn around soon.

Another development that shows just how shaky things have become stemmed from both Spain and Italy banning the short sale of stocks. The Spanish authorities decided to prohibit the short sale of all equities for the next three months, while Italy decided to limit the ban to some banking and insurance positions. It wasn’t that long ago that we had similar types of restrictions here in the U.S., so desperate times call for desperate measures. If that weren’t enough, Moody’s lowered the credit rating outlook for Germany and the Netherlands to negative, citing the rising uncertainty about Europe’s debt crisis. I think that was a gimme, since the countries who aren’t in dire straits would end up footing a large part of the bill anyway.

While Spain has been front-page news, the problems in Greece are still present, so the layers just keep getting thicker and thicker. I came across an interesting article about how the euro is becoming the new favorite as a funding currency for the carry trade. It only makes sense as the ECB has cut interest rates and the currency is trading near multiyear lows, or in some cases near-record lows, against several currencies. While this extremely volatile environment isn’t conducive to broad scale use of the carry trade, I think there is enough evidence to say it’s at least on the table. In the same breath of all this gloom and doom, some economists are saying that a depressed euro is exactly what’s needed to keep the euro together, given the effect on exports and increased breathing room.

I know that I’ve beat the stuffing out of this, but the euro problems had total market control yesterday. The global equity markets collectively fell yesterday, as Spain was public enemy No. 1 in just about every aspect around the world. The U.S. stock markets were no different, as both the Dow and S&P fell nearly 1%. The second-quarter earnings season hasn’t really done much to give investors something to cheer about. While company earnings on a whole have beat estimates, a majority of the sales growth figures have disappointed. While this can be viewed in two different ways, the lower sales just go to show consumers are continuing to struggle as the employment picture shows little sign of improvement.

The flight to liquidity was very evident yesterday as the 10-year Treasury fell to an all-time low of 1.40%. This just illustrates how much money has left the various financial markets and is currently sitting on the sidelines waiting to see where the marbles land. The price of oil really took it on the chin yesterday, for which I don’t even need to mention the cause, and ended the day around $88. Commodities in general suffered at the hands of Europe, with gold and silver even ending the day in negative territory.

As I mentioned earlier, the trading day was all but predetermined by the time I showed up bright and early yesterday morning. All of the currencies were sitting in the red, of course with the exception of the yen (JPY), with the emerging markets and high yielders taking the biggest hit. The interesting thing with all of the anti-euro sentiment in place, however, was the euro didn’t fall all that much on a percentage basis. The height of the dollar strength came right around 8:00 as the euro hit the low of the day and was sitting on a 0.60% loss against the dollar. Of the currencies that had losses, only the Singapore dollar (SGD) and Swiss franc (CHF) fared better at that point.

The two currencies that, once again, occupied spots in the cellar were the Mexican peso  (MXN) and South African rand (ZAR), as they ended the day with close to 1.5% and 2.0% losses, respectively. There weren’t any economic data released in either country that provided the extra kick, so this was simply due to the overall feelings of risk aversion. Both currencies began the day and ended the day in last place, so the hill proved too steep to climb.

We did see the currencies try to mount somewhat of a recovery around lunchtime, as the euro was ever so close to the break-even point on the day, but that was a short-lived phenomenon. I think there was an oversold feeling that managed to work itself into the market for a bit, but the feelings of concern and uncertainty proved too great of an opponent. With that said, the euro did manage to end the day in the 1.21 handle and was able to hold its spot near the top of the currencies, albeit at a loss.

An interesting turn of events took place as the afternoon progressed and we headed toward the close of business. There was another currency that joined the ranks of the yen in positive territory, as the Swedish krona (SEK) jumped ahead and turned in a decent showing, with nearly a 0.5% gain. This move was nothing more than a search for an alternative destination to the euro, as we didn’t see any economic news that would have provided the jump-start. The most-recent news from last week came in the way of central bank minutes that displayed a less-dovish tone than was originally expected. Policymakers dropped concern over its currency strength and kept its growth outlook unchanged.

With the euro ending the day close to break-even, the Norwegian krone (NOK) and Swiss franc were able to conserve energy and take a free ride. Speaking of the Swiss franc, a reader asked whether it’s likely they would remove the peg, or, properly phrased, the ceiling, to which they let it move via the euro, and allow the currency to freely float once again. The simple answer is not anytime soon. There is a lot at stake for the Swiss National Bank to stick to their guns on this, so I’ll give a brief explanation.

First of all, the SNB is in way too deep as far as a financial commitment is concerned. They not only have an immense amount of capital involved, but the central bank would lose all credibility if they switched horses midstream and decided to cave in. Any future action such as this would not hold any merit, and the market would immediately call their bluff with a direct challenge. That’s not to say it can’t still happen, but the market is at least taking them seriously right now. I would say that a Greek exit would pose the biggest challenge, as the flight to safety could prove too large an obstacle.

If the Swiss had it their way, they would like to see the franc depreciate even further so exports become cheaper and act as a catalyst to the internal economy. Not only that, deflation continues to be a reality, so a stronger currency would only act as a countermeasure in the battle against deflation. The exchange rate between the two countries is currently sitting on that 1.20 threshold, so the seams are certainly being tested, but the question as to whether the Swiss would willfully change the current strategy remains a resounding no. It’s a valid question, and I certainly appreciate the inquiry.

The Singapore dollar finished the day in the middle of the pack, with a 0.40% loss even though the June inflation report increased more than expected, to 5.3%, from 5%. The central bank uses the exchange rate, rather than interest rates, to help control inflation, which has remained at or above 5% over the past four months. The modest depreciation of the Chinese renminbi (CNY) has put a brake on any upward movement of the SGD, but as long as inflation remains elevated, the bias for a stronger currency should hold water.

As I came in this morning, there wasn’t much to report. The dollar is still sitting at the head of the table, and a good night’s sleep didn’t help to put the markets in a better mood. We did see a report of euro area services and manufacturing, via the purchasing managers’ index, hold steady at 46.4, but it did show contraction for a sixth straight month. As is the case with the PMI report here in the U.S., any number below 50 is what defines a contractionary number. The EU will release their second-quarter GDP figure on Aug. 14, so this is merely another reason to expect a negative number. Most economists are already calling for a follow-up in the third quarter.

Then There Was This: Germany and the International Monetary Fund are expected to refuse to provide an extra €50 billion in assistance requested by Greece. German newspaper Sueddeutsche Zeitung reported that the government and Greece’s major creditors won’t support aid beyond what has been approved. News magazine Der Spiegel reported that the IMF is taking the same position.

To recap: The problems in Europe maintained total control once again over the various financial markets. Spain has risen to the top of the concern list, as speculation the local governments could soon hit up the Bank of Spain for bailout assistance is becoming red-hot. One region has already made the move, and a handful of others may not be far behind. Given the situation, talk of an all-out sovereign bailout of Spain has become more likely and caused bond yields to hit record highs. As a result, flight to liquidity and risk aversion was the trade du jour. It just wasn’t a pretty day for the financial markets. The answer to the question of whether I think the Swiss will willfully allow their currency to freely float again at some point is not anytime soon. The Swedish krona managed to put together a decent day.

Mike Meyer
for The Daily Reckoning