Euro in free fall

The euro came under heavy pressure this week.
EUR-USD actually fell below 1.26 for a short time, but strengthened again to almost 1.28 at the end of the week. The single currency’s weakness was noticeable against almost all currencies. The chain reaction triggered by the Greek debt crisis spread rapidly this week. Bond and credit spreads of the peripheral countries soared and equity markets posted steep losses across the board. The ECB council meeting disappointed investors who had been hoping that the ECB would ease the pressure by buying debt-stricken countries’ bonds. The ECB dashed these hopes, however: according to Jean-Claude Trichet, the council did not even discuss this option.

With the renewed escalation of the crisis, attempts to calm down worries about the Greek debt crisis have failed once again. Only last weekend, the Greek government had agreed with the IMF, the EU Commission and the ECB on an ambitious multi-year fiscal consolidation package, thus creating the necessary prerequisites for financial aid for three years offered by eurozone member states to be made available. Hopes that the €110 billion bail-out package would suffice to cover Greece’s funding requirements faded all too soon, however. Furthermore, given the vehement protests, markets are still doubtful whether the Greek government will in fact be able to implement the austerity measures.

Thus bond and credit spreads in the debt-stricken countries shot up to new record highs, while investors continued to rush into quality. Yields on 2-year German government bonds are now only around 0.5%; 10-year Bund yields fell to fresh lows too, and US Treasuries were also in demand. The losses in the peripheral countries are putting the European banking system under increasing pressure. Asset swap spreads have widened sharply in the last few days. As banks’ balance sheets contain numerous bonds of debtstricken countries, risks for banks in Europe are estimated to have grown significantly again.

Up to now it is not clear how and whether the chain reaction can be stopped. Risk aversion is heightening every day, which in turn is increasing the risk of further member states losing access to capital markets. Admittedly, Spain successfully launched a 5-year bond yesterday, albeit with much higher interest rates. Ultimately, EU government leaders and the ECB will have to decide how to react if investors were to boycott buying bonds issued by the peripheral nations. In the short term, the ECB would then hardly be able to avoid purchasing government bonds on a larger scale. One permanent solution might be for the eurozone to issue joint bonds, which would prevent speculation against one particular country. However, comments by central bankers and policymakers suggest that they are not yet prepared to take such a step.

Economic development has become almost irrelevant – despite extremely upbeat data again; industrial new orders and production in Germany soared in March, thus confirming the very positive sentiment indicators. Everything is indicating that growth in the eurozone will rebound significantly in the second quarter. It remains to be seen to what extent the debt crisis will dampen the upswing again in the subsequent quarters.