Escalating eurozone contagion fears weigh on euro

The week’s start was tainted by last Friday’s disappointing non-farm payrolls, and over the weekend, even though China reported a stronger trade balance, results continued to add to overall concerns as these came at the cost of lower imports. China also released its consumer price index (CPI) figures for June, and these came out higher than the previous and expected figures, thus raising concerns of more tightening from the world’s second largest economy.

Earlier this week Italy and Spain gained more of the limelight and with the eurozone showing some willingness to digest the idea of a selective default for Greece the euro found itself under renewed selling pressure.

Reuters reported that when asked about the possibility of a selective default for Greece, Dutch Finance Minister Jan Kees de Jager replied that the group of eurozone finance ministers no longer excluded it.

Mr de Jager was speaking ahead of European finance ministers’ meeting. He also implied that opening the option for selective default should facilitate discussions now that the ideas of private sector involvement and the possibility of a selective default may co-exist. Previously, while selective default was being avoided, it was difficult to discuss private sector involvement.

The spreads between the benchmark 10 year German Credit Default Swap (CDS) and 10 year CDS for Italy and Spain continued to widen substantially, pushing up the costs for protection against default. The buyer of a CDS gets credit protection and thus effectively transfers the risk of default from the holder of the fixed income security to the seller of the Swap.

Rising contagion fears translate in higher CDS costs for those countries seen as most likely to default. As investors sell-off the respective sovereign bonds for the troubled nations they push prices lower and effectively increase the yield demanded to hold the particular sovereign bond.

Excessively high yields increase the burdens on these debt ridden countries and many times push these nations to ask for bailout funds instead.

We’ve already seen that but the issue with Spain and Italy is their size. Italy is the third largest economy in the eurozone, while Spain ranks fourth. A potential bailout to one of these countries would dwarf the bailouts so far handed to Greece, Ireland and Portugal.

All these events eroded risk optimism and as risk aversion crept in, currency flows favoured support for those currencies perceived to be “safer”; the Swiss Franc, the USD and the JPY. The concerns surrounding the USD and the JPY traditionally take the back seat when it comes to elevated risk aversion.

A particularly interesting currency pair, the EUR/CHF, managed to break record lows (as the Swiss franc strengthened). For the former part of this week the EUR/CHF traded in the range of 1.1552-1.1921 marking new record lows for the currency pair. This currency pair is of particular interest given the ailing euro contrasts sharply with untainted, ultimate safe haven – the CHF.

For the earlier part of the week, on average against the majors, the Swissie is gaining around 1.70 per cent, the USD is up 1.09 per cent while the yen is up 2.48 per cent – gaining momentum from the unwinding of carry trades.

Gold as well boasted a remarkable level of demand; the precious metal rallied gains for six consecutive days and in the process gained around 4.70 per cent up to the time of writing. Gold traded in the range of $1541.92 - $1557.02 for the former part of the week, just some pips away from the recent all time highs of $1577.20, reached last May.

Last Tuesday the UK reported its CPI figure for the month of June.

Actual figures showed that inflationary pressures eased slightly as CPI for the month declined by 0.1 per cent, while the yearly figure eased to 4.2 per cent from the previous 4.5 per cent. Concurrent to the CPI release the UK also released its trade balance figures and actual numbers showed that the trade deficit worsened throughout the month of May.

Immediately at the time of the releases the GBP/USD dropped rapidly and although the USD gave back some of its gains soon after, the drop to 1.5780 marked new daily lows, which had last been touched five and a half months ago, towards the end of January.

The EUR/GBP traded in the range of 0.8749 - 0.8891 for the former part of the week. We see support in the 0.8741 - 0.8780 region, while resistance lies in between 0.8875 - 0.8931.

Upcoming FX key events:
Today: Eurozone HICP, US Advance Retail Sales and US PPI.
Tomorrow: Eurozone Trade Balance, US CPI & Michigan Consumer Sentiment.

FX technical key points:
EUR/USD is bearish, target 1.3750, key reversal point 1.4578.
EUR/GBP is bearish, target 0.8700, key reversal point 0.9050.
USD/JPY is neutral.
GBP/USD is bearish, target 1.5700, key reversal point 1.6500.
USD/CHF is bearish, target 0.8200, key reversal point 0.90.
AUD/USD is neutral.
NZD/USD is neutral.

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Mr Muscat is a senior trader at RTFX Ltd.