More Euro Difficulties Seem Likely

Yesterday in Madrid Spanish Prime Minister Mariano Rajoy, bending to the wishes of Berlin and Brussels, announced the next dose of austerity, intended to produce €65B in savings. The previous austerity measures have sent unemployment soaring, 24% overall and up 50% for the young, and has resulted in contraction of economic activity and reduced tax receipts.

The additional austerity will include an increase in the VAT to 21%, (still less than the 23% here in Ireland) a cut in jobless benefits, a salary cut for state employees, and local government reforms, including the elimination of year-end bonuses to civil servants. Granted some of these reforms are needed. Decades of prosperity have elevated the salaries and fringe benefits of the public sector to levels higher than the private sector they theoretically serve, in many countries.

But these changes will not be well received. In Madrid there was violence as the riot police clashed with protests by coal miners.

When PM Rajoy returned from the most recent summit, he claimed that the ECB would help keep lower rates, and the European Stability Mechanism (ESM) would be in place later in the year, which would allow a direct rescue of ailing banks.

It took less than a week after the meeting for the Spanish 10-year rate to go back above 7%. Recently, the Spanish auctions have been small, between €2/3B, and it is estimated most of the bond buyers are the Spanish Banks, and a few pension funds. The current auctions are based on the assumption the current budget target deficit of -5.3% will be achieved.

From a Credit Suisse source, this means there is only €34B debt left to issue for the year. The debt, however, is going to exceed the target, since the austerity contracts the economy. There are also regional deficits, so the size of the Spanish auctions for the balance of the year will be increasing, perhaps to as much as €5.0B per auction.

Where will the Government find the buyers for the additional debt? The ECB has recently changed rules and may no longer accept bank-issued government bonds as collateral. Who will step forward to buy the coming expanded supply of Spanish debt?

As for the ESM which will be providing funds for the direct rescue of banks later this year, news from Germany does not sound promising. It was reported by Ambrose Evans-Pritchard that Merkel does not have authority from the Bundestag to lend money directly to banks. Further, the constitutional court ruled last September that there must be pre-approval of any future bail outs.

The Euro sell-off has been severe, but we are unable to even get the proverbial dead cat bounce. With the market as short as it has been, this is amazing. We did notice in our last COT report, the specs were coming out of their short positions. If you are a Euro bear, and no longer short the chances, are you are anxious to reinstate your position? Failure to rally to the top side of 1.03 is discouraging. Granted the FOMC notes, coming this afternoon might be USD bearish, and give us a rally, but that rally had best be sold.