In the Midst of Eurozone's Decline, Nations' Credit Still up for Debate

Last week I wrote about the puzzling market reaction to the disappointing EU Summit, but the delayed response finally came at the start of this past week’s trading. EUR/USD collapsed below recent range lows in the 1.3220/50 area, forcing a flood of option-related selling on the break down, before bottoming around 1.2950 and finishing the week just above the 1.3000 level. Reasonably successful bond auctions from Spain and Italy later in the week calmed markets’ worst fears, but Italian government 10 year yields remain elevated at 6.55%, and the TED spread (a measure of inter-bank lending costs) continued to climb to its highest for the year, indicating that severe market stress remains both in sovereign debt markets and the European banking sector.

The plunge in the EUR can best be seen as the markets’ verdict on the EU Summit and the absence of a viable solution to the EU debt crisis. It’s also a judgment that the new fiscal compact agreed at the Summit simply consigns many Eurozone economies to years of weak growth and increases their painful debt burdens, while doing nothing to improve their ability to re-pay. No doubt the decline in the EUR was partly fueled by year-end liquidity conditions, but the selling volumes were indeed massive and suggest a potentially pivotal shift lower for the single currency. Lastly, the EUR’s decline also represents markets’ pricing-in of the likelihood of ratings downgrades before the end of January.

Short positioning in EUR/USD has surged to its highest level for the year as of last Tuesday, according to Friday’s Commitment of Traders Report for futures. The so-called net short position in EUR has reached levels last seen in May 2010, as the EU debt crisis was just heating up and EUR/USD was breaking below 1.25 on its way to below 1.20. Excessive short-positioning may limit the immediate downside in the final trading weeks of the year, but year-end price moves are always difficult to gauge. We will stay focused on the downside, with immediate pressure while below 1.3100/50. A move above there could see a correction higher to re-test the key break level at 1.3230/60, which we would view as an opportunity to re-establish short EUR positions. The 1.2940/50 low for the past week is the pivot to a test down to the 2011 lows seen in January at 1.2860/70. Spreads between 2-year German and US Treasury rates suggest EUR/USD could see lower to the 1.2650/2700 area before finding relative value.

Ratings agencies on the move

We are still waiting for the formal pronouncements from the various ratings agencies on the fate of Europe’s sovereign ratings post-summit, but we still expect multiple one-notch downgrades for many of the most indebted governments and potentially a few of the remaining AAA-rated countries. Early in the week Moody’s announced it was placing most of the Eurozone’s ratings on review for a downgrade, including the EU itself. On Friday, Fitch announced it was lowering France’s outlook to negative, though it affirmed Frances AAA rating for the time being; Fitch’s review is expected to be completed by the end of January. Fitch also placed Spain, Italy, Belgium Slovenia, and Ireland on ‘rating watch negative.’ Perhaps most ominously, Fitch declared that a ‘comprehensive solution’ to the EU debt crisis is “technically and politically beyond reach,” adding “Of particular concern is the absence of a credible financial backstop” and going so far as to call for “a more active and explicit commitment from the ECB.” I don’t look for the ECB to heed that call and think they will stick to providing support to the banking sector and let government ratings take the hit. We may still see S&P deliver its ratings assessment before the end of the year.

Commodities may be set for a break lower

Commodities have been leading risky assets lower for some time, responding as they do to deteriorating global growth conditions and the implicit lowering of demand for commodities. Weakening Chinese growth outlooks have been the main culprit here, but I expect prospects of a Eurozone recession will likely keep commodities on the soft side more durably. Oil prices (US oil/WTI) have failed once again above $100/bbl and are within reach of testing inside the daily Ichimoku cloud, the top of which rises to 92.30-95.80 next week. Gold prices collapsed back below its daily cloud and looks set to close below $1600/oz for the first time since July. I am also watching the broad-based CRB commodity index which broke below trend line support dating back to the start of the major advance in 2009 and is so far holding above critical horizontal support at 290/95. A break below there would likely signal a much larger commodity sell-off, potentially on the order of another 10-15%. I look at commodities as leading indicators for moves in other risk assets, and for the moment they’re hinting at the potential for a greater risk-off move heading into year-end. This would be consistent with the US dollar index breaking up above its weekly Ichimoku cloud and closing above the psychologically significant 80.00 level for the first time since late 2010.