Dollar Broadly Firmer As Contagion Spreads To Spain In Europe

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  • Dollar, yen and Swiss franc are trading firmer; US data today to take back seat to Greek drama
  • Contagion spreading as Spain auction was weak, 10-year yield at record highs
  • EM to remain under pressure as spillover from Greece uncertainty set to continue into July
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The dollar, yen and Swiss franc are trading firmer as the contagion from the political deadlock surrounding Greece continues to unsettle global markets. Benchmark equity futures are weaker across the board. The Euro Stoxx 50 is down 1.2% this morning, led by European financials (-1.7%) as rating houses remain active in signaling downgrade risk. The Sep11 CBOE Vix contract is up 6% to 22.25, the highest since 24 May on record volume increase for the year (up 95% on the day). Peripheral euro zone yields are higher across the board: 2yr Greek yields are up 93bps, Portugal +47bps, Ireland +20bps, Spain +24bps, Italy +5bps. Bunds outperformance on safe haven flows has pushed 2yr yields down 6bps to 1.444% and lowered the 2yr Germany/USD spread to 108bps, the lowest since early April. Crude oil is trading through the 200-day moving average ($95.20) oscillating around the $95bbl mark. UK retail sales were weaker than expected, while SNB left policy unchanged, as expected. Markets await Greek cabinet reshuffle and confidence vote.

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Once again, the inability of the euro zone policy-makers to act quickly has allowed problems to fester and contagion to spread. A quick solution that ensured Greece’s borrowing needs would be covered through 2013 would perhaps have avoided this current rout in global markets. Political and logistical considerations prevented this and markets are paying the price. Indeed, we have long warned that investors were too optimistic about getting a new deal for Greece, and today, EU’s Rehn confirmed that a “medium-term” solution won’t be seen until July. With a solution seen as unlikely near-term, we are seeing more euro zone countries coming under pressure.

Ominously, Spain, which had decoupled for months from the debt crisis, is now squarely back in the crosshairs. It didn’t help that Dutch central banker Wellink said in an interview that the EFSF may have to be doubled. By our reckoning, EFSF as it stands can cover Greece, Ireland, and Portugal, but not Spain. So, Wellink’s comments can be read as a tacit admission that things are going to get worse still. Market jitters saw weak demand for Spain’s auction to sell EUR 2.84 bln of paper. Amount sold was less than its maximum target and was at a higher yield than the previous auction. Spain’s 10-year bond yield is up 9 bp and making new historic highs today above 5.6%, and while it is still far from the 7% threshold that markets view as a tipping point for debt dynamics, it wouldn’t take more than a few more risk off trading days to get uncomfortably closer.

Clearly, uncertainty over Greek and rising contagion will continue to weigh on the euro in the short-term with a downside break of $1.4150 today opening the door to test the May low around 1.40. After that is the 50% retracement level of the big January-May euro rally that comes in around 1.39. Developments are also likely to keep CHF bid. With EUR/CHF breaking below 1.20 to new historic lows, the downside there is also likely to be extended near-term. A Greek deal is needed to restore some stability in the markets, and while officials appear to be targeting July, we are hopeful that current market reactions will lead the parties involved into getting it done sooner rather than later. Our base case scenario remains that Greece will get the money needed to cover its debt obligations into 2013 or 2014 in return for greater austerity. But the fact that Spain may be getting drawn into the contagion is a new worrisome element that could be a game-changer that takes negative market sentiment to a new level. Officials in Europe must be aware of this, and is another reason not to dither until July with regards to Greece.

§ RBI hiked 25 bp as expected, but focus is squarely on G10 and the euro zone in terms of EM drivers. We continue to believe that EM will remain under pressure near-term but with eventual decoupling as Greece eventually gets the new aid program and averts default and restructuring for now. We suspect that forthcoming EM central bank meetings, including Colombia on Friday, will increasingly start to acknowledge greater risks to global growth and uncertainty over events in Europe. A more dovish bent may work its way into EM central bank thinking, especially with commodity and energy prices sharply lower as a result of current market gyrations stemming from Greece. EM policy-makers are probably a bit relieved that their currencies are weakening, but this could quickly turn to alarm if the currencies go off the rails and weaken too much. That will depend largely on how the Greek situation is resolved in the coming days and weeks, in our view.

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