After higher yielding and risk-correlated assets, such as the Australian Dollar and Euro, lost ground against the U.S. Dollar in Asian trading on Thursday, risk-appetite found support during early European trading, floating higher on lower volume across European equity markets. The shift back to risk-appetite gained steam just before 09:30 GMT after Reuters released a report citing a document outlining the possible expanded capabilities of the European Financial Stability Fund.
According to the Reuters report, the EFSF would be able to buy bonds on the secondary market if a given Euro-zone country has no bank solvency problems and has historically good borrowing costs. The European Commission and European Central Bank would then prepare an agreement with the Euro-zone country in 1 to 2 days, specifying how long the secondary market purchases would take. Finally, after buying bonds on the secondary market, the EFSF would have the ability to sell them back on the market, hold them to maturity, sell them back to the issuing sovereign, or use for repo.
In other major news, according to a draft of a debt inspectors’ report obtained by the Associated Press, “Greece's international creditors warn that a second rescue package tentatively agreed in July may not be enough to save the country from bankruptcy, but believe Athens should nevertheless get its next batch of bailout loans.” The report also stated that “[A]lthough the inspectors said Greece has missed its deficit-cutting targets and that the pace of its reforms is insufficient, they said Athens should get euro8 billion ($11 billion) of bailout loans as soon as possible so the country does not default on its debts next month.”
While Greece has been a repeat offender in terms failing to meet their budgetary obligations, the ramifications of this unconditional bailout now extend to Italy and Spain. The formula that European leaders have been using to solve the debt crisis – cut spending by imposing intense austerity measures – has not and will not work (as history has shown). In Greece’s case, austerity has only increased social unrest, leading to strikes, bringing the country’s economy to a grinding halt. This in and of itself has lead to Greece being unable to meet its budgetary obligations. Using Greece as a case example, why would Italy and Spain want to risk violent protests (which were occurring between police officers and protesters in Athens at the time this report was written) in order to receive bailout funds that they will undoubtedly receive anyway? This decision making has now opened up the door to a wave of sovereign moral hazard in the future.
Going forward, the longer-term bearish outlook remains intact, and will only be invalidated upon a technical break of the highs set in September (AUD/USD: 1.0763; EUR/USD: 1.4385). Moves above these levels would break the descending trend of lower highs and lower lows over the past three-months. This outlook is contingent upon further delayed policy response by European leaders in containing the sovereign debt crisis; should a credible plan materialize that addresses the fundamental structural issues plaguing Euro-zone fiscal policy, on a regional as well as on an individual sovereign nation level, we should expect the risk-aversion trend to end. The recent squabbling between Euro-zone leaders has not helped this sentiment in the past few days, and with the German leadership block now threatening to post-pone the long-awaited Euro-zone summit this weekend, the next few days could prove to be exceptionally volatile.