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Spain banks may throw spanner into euro rally

Source: Reuters - Mon 18th Apr 2011

Investors have yet to price in the cost of recapitalising Spanish banks, and this could see the euro pull back from 15-month highs against the dollar, though a test of $1.50 within the next few months is still on the cards.

The euro hit $1.4521 this week, its highest since January 2010, and is up 8 percent so far this year as Asian central banks diversify out of the U.S. dollar into the single currency and investors price in more monetary tightening by the European Central Bank (ECB) in the coming months.

Analysts say the currency market is underestimating the cost of recapitalising Spain's troubled banking sector and the associated risk of contagion, with many fixiated on interest rate differentials between the euro zone, the U.S. and Japan.

This week talk of a possible restructuring of Greek debt and a Moody's warning about Ireland's fiscal outlook brought the euro zone's unresolved crisis back into focus.

"If the Spanish funding situation deteriorates significantly in part on the back of intensifying contagion from Greece and Portugal and in part on the back of more losses in the Spanish banking sector, we could see the euro easing well below its recent highs," said Valentin Marinov, forex strategist at Citi.

"But as long as that does not happen, any correction in the euro is likely to be fairly muted as we will see buying by sovereign names at lower levels."

Spanish regional banks - or cajas - which are at the heart of its problem after taking on too much risk during the country's real estate bubble need at least 15 billion euros of fresh capital, according to the government.

That is fairly conservative with some analysts estimating the shortfall at as high as 120 billion euros when future losses related to real estate writedowns are included and as ECB rate hikes add to more losses to their mortgage portfolios.

"The need for considerable further retrenchment in the Spanish state as well as in the domestic banking system carries significant negative implications," said Lena Komileva, global head of G-10 strategy at Brown Brothers Harriman.

"Spain's fundamental-policy mix carries the persistent risk of another, much more damaging debt crisis in the euro area."


Spain is under intense scrutiny by investors, concerned the euro zone's fourth largest economy might eventually follow Greece, Ireland and Portugal in seeking a European Union and International Monetary Fund-backed bailout.

The country could be too large to be bailed out using the existing euro zone's rescue fund, which increases the downside risks for the common currency.

Up to now, bond investors have differentiated between Spain and the rest of the highly-indented euro zone periphery.

Ten-year Spanish bonds have outperformed their Portuguese equivalent by around 40 basis points in April, extending a decoupling which started in December.

Spanish bonds last yielded 190 basis points more than the euro zone benchmark 10-year Bunds , down more than 80 basis points on the year.

The narrowing yield spread has a tight correlation with the euro , which many analysts say has been supported by reports that Asian powerhouse, China, is studying a proposal to invest billions in the struggling Spanish banking sector.

"Traders will be keen to see whatever can be gleaned about the true size of any government bailout for the banks to see if the added debt burden is worrisome enough to suspect Spain will not be able to keep its own house in order," said Ilya Spivak, strategist at FXCM, an online provider of forex trading.

"Needless to say, such an outcome would prove acutely negative for sentiment."


As investors pushed aside the sovereign debt crisis to focus on interest rate hikes, the euro has gained more than 12% since hitting a 4-month low of $1.2865 in January.

The ECB became the first G-3 central bank to raise rates last week since the global financial crisis broke in September 2008, with investors pricing in two more quarter percentage point rate rises before the year end.

In contrast, the U.S. Federal Reserve is not expected to tighten policy this year.

Analysts say while rate differentials are the driving factor now, intensified euro zone debt concerns could take over.

"The level of rate differentials points to euro grinding higher to $1.47 or even $1.50, but valuations, positioning, the absence of capital inflows all suggest the bulk of gains are behind us," Deutsche Bank said in a report.

It added that at $1.50, the euro is 30% above its purchasing power parity and historically, the currency has corrected itself by 10% in the subsequent 12 months. The bank recommends investors avoid jumping on the euro uptrend.

The options market shows there is some reluctance on the part of investors to push the euro much higher (or lower) in a hurry. Implied volatilities show investors are not anticipating sharp swings with one-month vols just above one-year lows at 9.50%.

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