Eurozone Looking Less Wobbly but Problems Could Return

05 January 2012 (PLANSPONSOREurope.com) - While the Eurozone is looking “less wobbly”, the first signs of returning problems will be when short-term government debt yields rise significantly, according to John R. Taylor, Jr. Chief Investment Officer at FX Concepts.

Taylor says that while the ECB’s first Long Term Refinancing Operation (LTRO) in late December was very successful in driving down government interest rates in the short end of the yield curve, for the longer-term interest rates remain consistently high.

“We will know problems in Europe are returning when short-term government debt yields rise significantly, but they are currently low so the current environment is benign. They probably won’t re-emerge until after the second LTRO on February 29. Until that time, the euro should trade sideways to higher, but then we expect it to turn sharply lower once debt problems escalate and it becomes clear Greece can’t be saved.

Nick Gartside, International Chief Investment Officer for Global Fixed Income at J.P. Morgan Asset Management, adds: “We’ve often described the issues in the Eurozone as like a (very) wobbly three legged stool with the legs being:  sovereign stress, bank fragility and weak public finances.  Arguably the stool is a little less wobbly, at least in the short term.  The ECB [European Central Bank] is capping Italian and Spanish bond yields (at the moment) at 7% and the ECBs 3 yr LTRO has effectively financed banks for 2012 by replacing a lot of the maturing senior bank debt.  Although the third leg, weak public finances, still looks shaky with the revision to the Spanish 2011 deficit to -8% from -6%.