Resistance to Spanish Woes

Spanish 10-year yields hit a new eurozone-era record of 6.83% after Fitch downgraded 18 Spanish banks, while adding that further eurozone sovereigns remain under threat.

The latest run-up in Spanish yields drives up the spread over German 10-year yields to 5.39%. It took 10 days of +5% spread between Spanish and German 10-year yields before Spain obtained a bailout. It took 16 days of +5% Greek spread over German yields for Athens to obtain its first bailout; 24 days of 5% Irish spread over German yields for Dublin to get bailed out; and 34 days of +5% Portuguese spreads over Germany before Lisbon was saved.

Most particularly about today’s action is the recurring divergence between a falling euro and rising equities (alongside risk currencies weighing on USD) before the Fitch downgrade triggered an-all round risk-off reversal. As we speak, markets are attempting to rebound into the green, leaving the euro behind and highlighting the possibility that further question marks in Spanish banks’ ability to recapitalise will not necessarily spill over to non-eurozone assets as far as contagion is concerned.

Combining the Spain bailout with expectations of a market-friendly outcome in Greek elections (New Democracy now leads over left-wing Syriza party) and signals for further QE in next week’s FOMC allows for an extension of the recent rebound in equity indices. This is already favouring the risk currencies of GBP, NZD and AUD, with CAD.

What about Italy?
Italian 10-year yields hit a five-month high of 6.30%, or 4.74% spread over its German counterpart. Italian spreads did enter the 5% territory in November for less than two weeks before the December LTRO crushed bond yields across the board. Markets will have reason to fret ahead of Thursday’s auction of three-year Italian BTPs (2.50% for €2.0-€3.0 bn) and eight-year BTPs (4.25% for €750mn-1.5 bn). The next fear metric will be in Italian bonds – 6.60% territory in 10-year yields and 5.0% bar in the Ita-Ger 10-year spread. With over €2 trillion in gross debt, the stakes are larger than in Spain, and any recurrence of these negative currents will have to be opposed by a fresh round of SMP by the ECB.

We expect EUR/USD to continue consolidating between the $1.2350-1.2700 range well into and beyond the Greek elections/FOMC meeting, which will trigger net-positive equities. Our base scenario of $1.20 target, followed by $1.18, is unlikely to materialise before the end of this summer.

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