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To default or not to default – that is the question.

As the markets focus once again on Greece’s ability to repay its debt, last month’s pop up in both Spanish and Italian yields caught the markets by surprise and posed the question –“Could Spain be the next bailout candidate?”

Spain has always been the canary in the coalmine and if it ever sought a bailout no type of rescue package would be big enough to save it – and if we did reach this stage then it’s highly likely the euro would simply have no further value as a currency.

Spain is fairly unique as it’s governed by 17 autonomous communities alongside a decentralized government. Each one of these has its own budget and the markets concern is that central government still does not have a true handle on the debt exposure of these 17 communities. The “hidden debt” problem first popped up in Catalonia after elections last autumn resulted in Catalan nationalists unseating a Socialist-led coalition. In December, the central finance ministry said the region’s debt-to-regional-GDP ratio was 1.7% as of the third quarter. The old government later disclosed the full-year deficit could be as high as 3.3%.

Last month’s Spanish elections saw more socialist regional governments voted out of office and the real fear that more hidden debts could emerge. Spain has made great efforts in cutting its deficit to 9.3% of GDP, however much of this has come from centralized government cuts.

The huge glut of unsold homes and the billions in bad property loans still lie on the balance sheets of mainly provincial banks that have yet to still fully disclose their liabilities. Spain certainly has a challenge ahead of it and with youth unemployment the highest in Europe at 44% it’s clear that it has a generation that will have to make tough sacrifices and decisions.
Greece remains the problem that just won’t go away. If life was simple Greece should take a haircut on 50% of its debt obligations and look to rebuild. However the risk of contagion would be far too great and this would spread to Portugal, Ireland, and even Spain. German banks would be forced to write off billions of euros and it would send the global economy back to the dark ages.

The solution the euro politicians have come up with is the term debt reprofiling. Put simply it would allow a country to roll over its debt obligations for a period of maybe 35 years. This would get round a technical default, that itself could trigger a wave of CDO claims as debt insurance would be triggered. As with anything in European politics nothing has yet to be decided but it’s clear the indebted southern nations can no longer devalue their currency, do not possess anything like the levels of growth needed to repay their debt and have reached levels of austerity that are no longer effective.

Sterling will remain under pressure as the UK economy looks like its hitting some turbulence as the consumer responds to the government’s tough austerity measures. It’s highly unlikely the Bank of England will hike rates in 2011 and the pound along with the dollar and euro will still be viewed as the 3 ugly sisters by the currency markets.

Keith Spitalnick LLB (Hons)

Regional Sales Manager

Currencies Direct

Plaza de las Orquídeas, Local 5, Nueva Andalucía, 29660, Marbella, Málaga, Spain

T: +34 952 906 581         M: +34 687 417 035

F: +34 951 279 392         E: keith.s@currenciesdirect.com

www.currenciesdirect.com

www.twitter.com/currencyblog

As the Euro zone struggles with its mountain of debt, the old trick of devaluing your domestic currency is no longer a resource the seventeen members can rely on as they all sit under the umbrella of one currency and one interest rate.

In the UK however, the Bank of England has been able to slash interest rates to levels not seen in over 400 years. At the same time they have talked the value of the pound down to levels not seen in 25 years when measured against a basket of global currencies so logic would assume that the UKexport industry must be booming….but this is not the case.

In the first instance you need to be an export driven nation, and the UK has long since seen both the financial and service sectors make up a much larger proportion of GDP than the export sector. Secondly the UK’s trade balance has actually widened – one of the reasons being that manufacturers still need to import basic materials to manufacture the goods they export. And lastly, UK companies that do export have used the weakness of the pound to increase their profit margins rather than make their goods more competitive in a global market.
So for the UK a weaker pound hasn’t really helped the economy recover. I could also argue that it is now in the best interest for the Bank of England to let the pound rally to monetise the high rate of inflation the UK currently suffers from.

The US has also seen its currency tumble, but this is more down to the actions of the Federal Reserve who have embarked on a series of Quantitative Easing programs, pumping billions of dollars into the global economy, forcing the dollar lower and commodity prices to records highs. Unlike the UK, inflation in the US remains low as the economy has a huge amount of spare capacity, with unemployment sticky around 9% and the housing market still extremely weak.

The worry for the markets is that US inflation may suddenly spike and the Fed may have to raise rates a lot faster than anticipated choking off any USeconomic revival and also putting pressure on the United State’s huge debt obligations as yields rise in the US treasury market.

The Aussie dollar is the currency that keeps on giving and it is difficult to see this changing. Australia has become China’s supplier for commodities and as China continues to expand, the Australian economy will flourish. Not to mention countless hedge funds and Central Banks keen to diversify out of the US Dollar are moving billions into the Australian dollar. And finally the Reserve Bank of Australia is likely to raise rates once again giving a yield of 5% … compare that to the UK, Eurozone or the US and you can see why the Aussie dollar is currently the darling of the currency markets.

Keith Spitalnick LLB (Hons)

Regional Sales Manager

Currencies Direct

Plaza de las Orquídeas, Local 5, Nueva Andalucía, 29660, Marbella, Málaga, Spain

T: +34 902 310 444         M: +34 687 417 035

F: +34 902 310 440         E: keith.s@currenciesdirect.com

www.currenciesdirect.com

www.twitter.com/currencyblog

Thought 2010 was tough?

Well if you thought 2010 was a tough year, 2011 will probably bring much the same for the currency markets, with volatility certain to be an ongoing theme.

Looking back at 2010, until the Eurozone debt crisis reignited at the start of October, Sterling had been rapidly losing ground to a dominant Euro. In September, when the Bank of England began to make noises about firing up the printing presses again with more quantitative easing, Sterling dropped back from just below €1.24 to levels as low as €1.12.

But a late showing of stronger data for the UK economy, (which quashed the threat of more quantitative easing for now), the Ireland bailout and the fear of Eurozone ‘contagion’ saw the pound recover to its current level, after briefly popping its head above the €1.19 parapet.

UK inflation remains high

To predict the direction of Sterling is a tricky call to make. Despite the UK economy struggling and unemployment levels starting to rise, inflation in the UK remains above the Bank of England target of 1-3% and is likely to increase even further in 2011. Whether inflation rises or falls is crucial for sterling, because if it remains around the 3% mark in the medium term, pressure will mount on the Bank to raise rates.

Call for interest rate hike

We have already seen one member of the Bank of England Monetary Policy Committee, Andrew Sentence, calling for an interest rate hike and the growing belief that when rates do rise in the UK they will go up very quickly which will have a positive effect on Sterling, possibly pushing it as high as 1.25-1.30 against the Euro. However any rate increase will probably not come until late 2011, so until then, the value of the pound will remain fairly range bound against currencies like the Euro.

Challenges for the Euro

The challenges facing the Euro in 2011 will be much the same as in 2010 – the need to service the debt of the southern European states. Italy, Spain and Portugal have to finance in excess of €800 billion of new and existing debt and should they find the market has no further appetite then the Euro could really start to fall apart.

China could come to the rescue of the Euro, as they certainly do not need their biggest trading partner imploding, and the Chinese are also keen to move away from having a huge dependency on the value of the US dollar.

So I am very intrigued as to the direction of the Euro over the next 12 months. The US dollar could be the surprise package in 2011 as growth rates for the US economy are upgraded, but once again this will probably not occur until late 2011.

Looking for certainty?

So if you’re looking for certainty, the only thing we can really be sure of is that volatility will once again be the key driver in 2011.

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