Spain casts a shadow over Europe

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The deteriorating situation in Spain (see below) was the main trigger for Friday’s distinctively bearish tone, a sentiment which infected Asia overnight. The single currency is threatening to break 1.30, down two big figures from Friday’s high in Asia.

European equities back-pedalled rapidly, with the Spanish IBEX 35 down 3.6% and the DAX 2.5% lower. Peripheral European bond yields were under continued pressure, with the Spanish 10yr bond yield near 6.0% again amidst reports that numerous Spanish banks need to borrow from the ECB. Video:


This followed news earlier in the day that Spanish bank borrowing from the ECB soared by 50% last month; moreover, these lenders have accounted for almost 30% of the total long-term loans offered by the ECB. This renewed bout of risk aversion provided both the dollar and the yen with a fresh boost. Interestingly, gold, that other safe-haven in times of panic, missed out again. Sterling outperformed most other currencies – EUR/GBP fell to 0.8230.

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Commentary

Switzerland’s titanic struggle. The most surprising thing about the crossing of the 1.20 line on EUR/CHF recently was that it took so long to happen. Even though the SNB downplayed the significance of the development, it is unlikely to be the last battle between the markets and the SNB. Recall back in September when the SNB announced a floor of 1.20 for EUR/CHF, stating that it was prepared to buy foreign currencies “in unlimited quantities” in order to enforce this rate. This immediately resulted in a substantial depreciation of the franc (of 8% vs. the EUR), with more losses for the CHF over subsequent weeks. Near the end of October, EUR/CHF reached a high of 1.2474. In contrast, this year the franc has stayed consistently within 2% of the 1.20 target, trading 0.6% away from it on average. More remarkable is that this has happened at a time when markets were supposedly in ’risk-on’ mode – during Q1, the S&P rose nearly 12%. Furthermore, the Swissie not only appreciated against the euro but also against most other major currencies, just beaten by the Scandi and high-yielding emerging currencies. As always with a currency, intervention tends only to work – especially unilaterally – when it’s pushing the currency in the direction of the prevailing winds of wider fundamentals rather than against them. During the SNB’s first round of intervention, between March 2009 and the middle of 2010, the CHF fell some 10% vs. the euro, with the initial depreciation unwound after about four months. As it is, the fundamentals of the Swiss economy have changed little since the cap was imposed and, if anything, have worked against the SNB’s aims. Deflation is more entrenched and carry has become less appealing in many currencies, reducing the incentive for investors to use the franc as a funding currency. This leaves the (leaderless) SNB defending the 1.20 level with a bazooka, but fending off attacks with a pea-shooter. It could raise the floor on EUR/CHF but, given what we’ve seen so far this year, that could be costly to defend and would not be without implications for the domestic economy in terms of containing the impact of the expansion of the monetary base. Little wonder there isn’t a queue of people wanting to lead the SNB right now. It could be a pretty thankless task.

Spain is on the edge. As so often occurs during a crisis, events are so fast-moving and far-reaching that it is often a tremendous challenge to keep up. On Thursday, the Rajoy Government gained parliamentary acceptance for a budget stability law which compels Spain to achieve a balanced budget by 2020. With the economy in rapid reverse, and likely to stay that way for some time, achieving this objective will be incredibly difficult. Last year’s fiscal deficit was 8.5% of GDP, or around EUR 90bn. Recognising that much of the fiscal slippage encountered last year occurred at the regional level, Rajoy continues to press the governments of these 17 autonomous regions to honour the budget commitments Spain has made to Brussels. A number of ministers have recently lambasted some of the regions for their excesses. The budget stability law just passed allows the central government to intervene in the financial affairs of regional fiscal miscreants. This in turn has lit the touch-paper on that perennially sensitive subject in Spain, namely regional autonomy. One of the major criticisms levelled at Spain over the past decade is the explosion in public sector employment and the attendant inefficiencies that often accompany such a huge headcount. As Rajoy and his senior finance officials have made clear, it remains imperative for Spain to convince international investors of its credit-worthiness, or else the country will suffer the same fate as the likes of Greece, Portugal and Ireland. Unfortunately, the constant brush-fires evident at the regional level are being replicated in the equally troubled banking sector. Although some Spanish banks took advantage of the ECB’s generous provision of liquidity via the LTRO, this has merely papered over the cratering being experienced on the asset side of their balance sheets. The Bank of Spain has already proposed that banks increase their provisions by EUR 50bn. Given the rapidity of the decline in property prices, this will likely need to be raised significantly. For good reason, the Rajoy government has received the plaudits of international leaders. However bond investors are more circumspect, suspecting that, despite his best endeavours, Rajoy will be unable to prevent Spain also falling into the hands of international creditors. The ECB must be desperately hoping that the latter does not occur. Ramping up the SMP will cause huge divisions within the ECB and another helicopter drop of liquidity via a third round of LTRO would look desperate and would probably also fail to mollify investors. As most money managers around the world now appreciate, Spain is the elephant in the room for the major asset classes.

Favourable UK anecdotals. It seems pretty clear that the UK economy avoided falling back into recession in the early months of this year. Indeed, some of the recent anecdotals have been reasonably cheery, a depiction that the UK has not enjoyed for a very long time. According to High St retailer John Lewis, its department store sales boomed 27% in the week leading up to Easter. Separately, a commercial property-development index calculated by Savills Plc rose to a two-year high last month, with those located in the South-East especially upbeat. Finally, house prices rose last month, according to Academetrics, buoyed by the expiry of a tax holiday.

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