Gold and dollar pop on euro debt crisis
This post is a guest contribution by Dian Chu, market analyst, trader and author of the EconMatters blog.
A year after Greece received a €110 billion ($158 billion) bailout package from the European Union (EU) and IMF, the resurgence of the European debt crisis serves to illustrate that you can not cure debt with more debt.
Greek debt is on its way to reach 157.7% of GDP this year, and will climb to 166.1% in 2012, according to the forecast by the European Commission (Fig. 1). The country also suffered a fresh sovereign debt downgrade from BB+ to B+ on Friday, May 20 by Fitch Rating, citing significant challenge to secure solvency of the state and sustained economic recovery.
U.S. – Looking Good By Comparison
Furthermore, since the U.S. is ahead of Europe in this Great Recession cycle, U.S. economy is also further into the recovery phase. There are signs of increasing consumer spending, which fuels about 60-70% of the U.S. GDP. For instance, in the first quarter of 2011, American Express, MasterCard and Visa all reported increases in card spending as credit condition gradually loosens, and consumers start using credit cards to build credit again in a slowly healing economy.
Most importantly, there’s a major difference between the U.S. debt situation and that of the Europe—the borrowing costs remain reasonable for the U.S. (Fig. 2) and there’s not an insolvency issue.
Risk Off – King Dollar & Gold
The euro depreciated to less than $1.40 for the first time since mid March on Monday, May 23, while gold, which typically has an inverse relationship with the Dollar, has now flipped into inverse with the Euro (Fig. 3).
Chapter 1 – Greece
Greek austerity measures have been met with intense domestic social and political resistance. But without a system wide total overhaul and reform, steep budget and spending cuts have failed to restore market confidence. The implied cost of borrowing on ten-year Greek bonds surged to 16.75%, a new euro record, more than twice the rate at the time of the bailout a year ago, while the country’s two-year bond yield is around 25%!
High debt along is not as bad if there’s enough growth and reasonable bond rate to repay and refinance debts. In the case of Greece, it is highly improbable that it could generate enough growth to afford the sky high premiums investors are asking to keep its debt afloat (Fig. 1).
Default, Haircut, Bailout or Exit?
Most economists believe Greece won’t be able to repay its €350 billion debt, so Greece is either going to default or need a new bailout. Many experts estimate a ‘haircut’, i.e., reducing the debt principal, of at least 50%, is required to get Greece debt under control.
Another drastic option is for Greece to exit Euro so it could devalue its currency to afford these debts. But that would involve a messy debt conversion process, and most likely a majority of the debt may still need to be paid back in euro.
High Exposure – ECB & European Banks
Banks in France, Germany and UK have the largest exposure to Greek debt (Fig. 4). Goldman Sachs estimated that a 60% haircut would wipe out as much as 80% of Tier 1 capital at Greek banks. In order to avoid contagion, these banks would need “pre-emptive” capital injections.
So needless to say, a default or a big enough ‘haircut’ could eventually result in the insolvency of Greek banks as well as the ECB, while causing some potentially serious damage to the entire European banking system.
Chapter 2 – Ireland, Portugal, Spain & Italy?
Clashing Views in Europe
However, ECB officials, clashing with European political leaders, have ruled out a Greek debt restructuring citing high risk of broad contagion.
Euro Chaos + End of QE2 = Dollar Gain
So with chaos in the Euro Zone, and as inflation trade comes off with the end of QE2, from a technical perspective, euro most likely would test 1.375 in June, 1.35 in two month, and 1.30 in the next four months, with strong support at 1.35 levels (See Chart).
Gold – Caught Between End of QE2 & Euro Chaos
From a technical point-of-view (See Chart), gold is in an upward momentum at the moment, and the next resistance should be at $1,550 with major resistance at $1,600, which would be a good point to short the yellow metal.
However, overall, I think gold would resume the historical inverse relationship with the dollar, barring any end-of-world-like events such as a war or multiple sovereign defaults. On that thesis, look for gold to test the downside of $1,500 in June/July with major support at $1,400. And the time to get out of gold would be when major central banks like the U.S. Federal Reserve and the ECB start to raise interest rates.
Source: Dian Chu, EconMatters, May 24, 2011.
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