EUR – Why Spain Will Cave in the Next 20 Days

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There are 4 central bank monetary policy announcements this week along with the U.S. non-farm payrolls report but despite these high profile events, the main focus is still Spain. Moody’s needs to decide whether or not to downgrade Spain to junk status and take investors out of their misery. Last night, the rating agency said Spain’s plan to recapitalize their banks is credit positive, but maybe not enough. In doing so, they teased the possibility of a downgrade but stopped short of making a definitive decision. For investors, this means continued uncertainty that won’t be lifted until Spain asks for bailout. Even if Moody’s spares Spain a downgrade, the financial community won’t be satisfied until the country asks for help and we think Spain will cave within the next 20 trading days.

Time is Running Out for Spain

Unfortunately the European Central Bank’s aggressive bond buying program and the Spanish government’s new reform measures failed to reverse the downtrend in the EUR/USD and now, time is running out. More than EUR20 billion worth of Spanish bonds are scheduled to mature this month – the single largest month of bond redemptions this year. If Spain fails to convince investors to reinvest their proceeds, they will need to procure enough cash to pay them out. What is even scarier is that according to the latest numbers released by Banco de Espana, the country’s cash balances are at its lowest levels in 2 years. While it is estimated that the September cash balance is higher, the key is the willingness of Spanish investors to reinvest. If they don’t then Spain will have no choice but to ask for help.

Perfect Window for a Bailout Request

Last week, the Spanish government outlined 43 new measures to boost growth and rein in the deficit. It is widely believed that their decision to go above and beyond in terms of laying out a detailed timetable for economic reforms is their way of paving the foundation for a bailout in the next few weeks. The hope is that if they outline new reform measures now, the European Union won’t ask for more cuts when Spain comes knocking on their door. Part of the reason why the Prime Minister has been holding off is because of regional elections on October 21st. A bailout would represent a major failure that could affect his party’s stronghold in key regions. Once the regional polls are out of the way however, the government must repay a EUR5.3 billion note maturing on October 29 and a EUR15 billion bond that matures on October 31st. Therefore the perfect window for Spain to ask for a bailout is between October 22nd and October 26th. If borrowing costs rise materially before then, due to a downgrade from Moody’s or pure risk aversion, they could cave even sooner.

When Spain finally asks for a bailout, we expect the euro to rally and equities to rise. While a bailout is terrible for the country because it reflects their complete failure at managing fiscal finances, investors will celebrate the removal of a major uncertainty that has hung over the markets for months. Over the past few weeks, the EUR/USD has fallen from a high of 1.3170 to a low of 1.2810. Further weakness is possible if the Spanish government continues to drag their heels but once a bailout request is made, the EUR/USD could be on its way back to 1.32.

The European Central Bank will have the opportunity this week to pressure the Spanish government to ask for an activation of Outright Monetary Transactions or reassure the market. While ECB President Draghi is likely to do both, his options are limited having just announced a new program which means the fate of the EUR/USD lies in the hands of Spain.

Kathy Lien
Managing Director

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