The final lap for EFSF enlargement

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Slovakia is having its day in the sun today as it votes on the expansion of the European Financial Stability Facility (EFSF) today, the last of the 17 eurozone members to do so.  Some are fretting that this could de-rail the EFSF expansion process, but this has all the hallmarks of a sovereign hissy-fit, rather than anything more significant.  Slovakia says that it is unable to afford to bail-out more affluent countries, with GDP per head only 40% that of Germany’s.  That’s precisely the reason that it can’t afford to reject the EFSF expansion, with Slovakia needing the EU/euro far more than the eurozone needs it. 

Of course, this is not to say they will get booted out if they reject it, just that the EU (as has been indicated) will find away to go ahead anyway.  The single currency was notable for its gains vs. the dollar yesterday, the biggest gain since 1st July last year, but don’t be fooled by this, given that there were plenty of currencies gaining more (Scandis, Aussie and Swiss franc).  The dollar index put in its worst daily performance (down 1.56%) since 15th December 2008. The euro is merely riding on the coattails of the weaker dollar, nothing more.

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Commentary

Dollar’s decline on falling fear.  As we were intimating last week, risk assets were bound to improve once European policy officials finally understood that radical action was required to rectify the inadequate capital positions of their major banks. High-beta currencies surged again yesterday with the Aussie touching parity (up more than 5% in less than a week), Scandi currencies surging and the Brazilian real suddenly has a new mojo. Asian currencies have recovered as well after their recent battering; for instance, the South Korean won is up 3% from last Tuesday’s low. Both equities and commodities have returned to favour, with Brent crude at USD 106 a barrel and global equities 5% higher than last Tuesday’s low. After a two-month meltdown of risk assets, some reversal was to be expected. Bargain-hunters have recently been sniffing over the carcass of beaten-down assets and currencies, looking for value. Trader positions in commodities, high-beta currencies and the euro had become exceedingly short and were vulnerable to only the slightest shift in sentiment. The approach of calendar year-end is also encouraging those hedge-fund managers and investment bankers who made a fortune shorting risk assets in Q3 to gradually close-out/reduce their positions. For the dollar, that over recent weeks was viewed as the place to keep your money while Europe was combusting, this short-covering of risk assets/currencies – and of the euro – is resulting in a further diminution of its recent gains. In the near term, should this process continue, then the dollar may encounter some further slippage.

The growing reach of European banks.  The implications of the weekend’s developments with regards to the search for a way ahead for the European banking sector is less in the detail and more in recent market action. Of course, the detail is lacking, with Sarkozy and Merkel having pledged to put the flesh on the bones over the coming two weeks. What is of more significance is the way in which sentiment towards European banks is impacting many other markets now, in other words evidence that the European sovereign crisis is becoming the new risk barometer for global financial markets. The inverse correlation between the single currency (trade-weighted index) and the senior financial CDS index has been increasing steadily over the past month, currently around -0.68 from having been around -0.30 early in September (based on 1mth rolling correlation on percent changes). This is not the strongest inverse correlation we’ve seen this year (-0.80 towards the end of July), but it’s not far off. However what’s more interesting is the way in which other asset classes are being drawn in. At the start of the year, there was a positive correlation between AUD/JPY and the Euro senior financial CDS index. This is now firmly in negative territory and has become more so over the past month, currently at -0.62. A similar pattern is evident with Asian equities. Now, the saying goes that the only thing to go up during a crisis is correlations as everyone rushes for the exits. There’s certainly some truth in this, but it’s also the case that the European banking sector is becoming increasingly influential in many more risk assets. That’s why the flesh that is put on the bones of the weekend’s plan is so key for many financial markets.

The danger Dexia poses for Belgium.  To its credit, Moody’s has reacted promptly to the dangers posed by the Dexia break-up, placing Belgium’s Aa1 local and foreign currency rating under review for possible downgrade. The focus of its review, understandably, will be the significant increase in contingent liabilities Belgium is taking on, at a time when its public debt/GDP ratio is already over 100%. For those troubled by Belgium, it is not the EUR 4bln price tag for acquiring Dexia SA’s consumer-lending unit that is the problem. Rather, it is the fact that the government has vowed to guarantee 60.5% of up to EUR 90bln of Dexia’s interbank and bond funding for up to ten years that is unsettling. This follows a similar gesture back in 2008 when Dexia was in serious trouble the first time and on that occasion it was a guarantee of 60.5% on up to EUR 150bln of borrowing. As a sovereign credit, Belgium remains vulnerable to a further loss of investor confidence. Sixteen months after a general election, Belgium still does not quite yet have a government, the economy is meandering along and now there is a new substantial burden which the taxpayers will be accountable for. Little wonder that Belgian bonds have taken fright – the ten-year bond yield is now above 4.0%, a rise of 40bp in the last few sessions and double the yield of Germany.  It is still the likes of Spain and Italy that are the elephants in the room in terms of the euro’s survival, but Belgium’s precarious plight should not be ignored either.

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