Are markets pricing in a euro break-up?

Despite the growing problems of the euro-zone’s southern and peripheral economies, the markets had been showing remarkable faith in the future of the single currency bloc. Investors had been moving their money into the “safety” of the core economies as bond yields rose in the more economically challenged ones.

Meanwhile, the euro currency itself has remained very resilient. However, over the past couple of weeks the situation seems to be starting to change. The upward pressure on bond yields has now begun to spread from the peripheral markets into the core, with the likes of France, Austria and Belgium now seeing sharp rises in their borrowing costs. Meanwhile, the euro has fallen by some 3% against the U.S. dollar since Halloween.

In short, there is evidence that investors have now started to beat a more general retreat from the euro-zone. The inability of Policymakers to properly handle the crisis in Greece has shaken investors’ confidence in the EU’s ability to take the actions needed to keep the euro-zone together (see our Question of the Week).

Markets once again took their cues from headline developments in Europe where bond yields both rose and fell as the European Central Bank (ECB) continues to show intermittent commitment to its buying of Italian and Spanish debt. By midweek, a report from Fitch Ratings said that further European contagion poses a risk to American banks caused U.S. stocks to tumble, crude oil to slip back below the $100/bbl level, and gold to fall below $1750/oz for about a 4% decline on the week.

Canadian stocks fell this week (S&P/TSX down nearly 3%), led lower by raw materials producers as concerns about global growth intensified. The Canadian dollar did slide for most of the week until the Canadian inflation report showed slightly higher consumer prices in October. The leading indicators on our economy were also higher due to gains in the housing market. The Canadian dollar bounced off its one month low to finish slightly higher but still down for the week.

A silver lining on what was a down week was much of the data on the U.S. economy. Weekly jobless claims were again lower than economists were expecting, retail sales in October were almost double expectations, and even housing starts are showing signs the economy may be shifting into a higher gear.

Excitement Ahead of the November Jobs Report

In contrast to developments in Europe, the U.S. economy showed signs of improvement in its two weakest areas; housing and employment. Claims for unemployment benefits dropped to the lowest level in seven months and for the second consecutive week below the critical 400,000 level. Fewer firings may signal companies are closer hiring back more workers, helping to reduce a stubbornly high unemployment rate. Also, Housing starts exceeded forecasts with building permits, a proxy for future construction, jumping 11%. Now if only some of that positive news could hit the headlines ahead of the seemingly endless European debt situation…

The Trading Week Ahead

A very busy data and event week will be compressed into only three days as the U.S. celebrates their Thanksgiving on Thursday. While markets are open Friday, many Americans will shop ‘til they drop’ at the local shopping malls on what is the busiest shopping day of the year, or what retailers refer to as ‘Black Friday’.

Before the trading week begins, Spaniards will be voting in a general election on Sunday. Spain is already reeling from its worst recession in the past 60 years and its people are expected to be voting for more economic pain as polls show they will elect a majority government with the mandate to cut the Spanish deficit by about one third. This will be the fifth European government toppled by the debt crisis.

On Tuesday, U.S. home sales for October will try to build on the recent string of more positive economic data coming out of the world’s largest economy. Third quarter GDP revisions will also show how the American economy is standing up to the headwinds emanating out of Europe. The notes of the most recent Federal Open Market Committee meeting may give investors more insight into the thoughts and future course of actions by the U.S. central bank.

Wednesday is the biggest information day with markets closed on Thursday. Investors will look to see if jobless claims can come in under 400,000 for the third week in a row. The drop below the 400,000 level is psychologically important because it is the level normally associated with more stable job growth.

As has been the case for some time now, the headline news out of Europe will continue to influence both the direction and magnitude of risk market moves in the week ahead.

Question of the Week

With credit spreads widening in Spanish, Italian and even French bonds this week, it appears Europe has reached a crossroad: print more Euros to re-ignite growth or continue to press leaders for government reform. Which is the best option?

Not only have Spanish and Italian bond yields have blown out against German Bunds but now there are suggestions that even Bunds are losing their safe haven status as Germany looks like it is headed for a recession. The debt contagion has swiftly moved from the periphery to the core of the Euro zone in the past two weeks.

From an investors’ perspective the idea that the ECB essentially print Euros would the most positive move for global markets and risk assets. The ECB could orchestrate currency devaluation by the printing of more Euros to purchase the debt of the sovereign nations currently having trouble refinancing at soaring rates. ECB buying of sovereign debt would see yields decrease dramatically and allow those defunct governments to refinance themselves at much lower rates. It doesn’t solve the problem, but it buys time to fix the longer term imbalances.

Several problems exist with firing up the printing press not the least of which is the concept of a “Moral Hazard” which essentially pardons poor fiscal behavior without recourse. In essence, the ECB would be changing its mandate and becoming the lender of last resort. This is something to which Germany is staunchly opposed. Germany wants the pain of Euro zone deleveraging to be borne by all, not just the ECB balance sheet. Also, with the Euro currency diminishing in value substantially, inflation would likely become rampant reminiscent of the great inflation of the early 1920s.

A second alternative is that the ECB remains steadfast and tries to force governments to move on reforms faster than the capital markets expect them to. This notion is flawed on two counts. Markets are discounting machines and they move at light speed to price future events. As well, Europe lacks complete fiscal unity. Fiscal unity would mean all nations follow a single culture on spending and saving and that is unlikely in Europe. What is certain is that bond yields will likely continue to rise until investors have an incentive to hold on to the debt. If the ECB only wants to buy a few bonds here and there while politicians debate reforms investment markets will continue to teeter on the brink of uncertainty.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP