Morning Commentary: Teamwork Doesn’t Always Make the Dream Work

Foreign Exchange - Morning Commentary
Teamwork Doesn’t Always Make the Dream Work  
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
U.S. equity markets have opened higher this morning and will look to continue its string of gains from last week.  There are multiple factors that have fed into the market’s positive sentiment with reopening plans being the most significant of these.  In the U.S., NY Governor Cuomo set out a phased plan to reopen NY as soon as May 15.  Over in Europe, Spain, Italy and France have followed Germany’s lead in putting out more concrete plans to reopen the economy over the next few weeks.  For today, the USD is weaker and the euro is stronger, but over a longer timeframe, the picture still remains bleak for Europe.   

The current crisis will deliver a shock to both growth and debt levels and complicates the debt picture for the most indebted countries, especially without debt mutualization as Italy shows.  By this summer, the Italian economy will be roughly the same size as it was when the euro was launched in 1999.  As a result, Italy has been unable to outgrow its debt legacy and this is unlikely to change going forward. 

For Europe, the general “whatever it takes” to fight COVID-19 headwinds narrative out of policymakers failed to overcome the philosophical difference between individual commitments and collective responsibility.  This lack of substantive discussion on the extent that the fiscal burden will be pooled as the Eurozone faces ballooning COVID-19 costs is of particular concern. 

Without debt mutualization, Italy will be required to run a larger budget surplus to stabilize its debt.  This is unlikely to happen which means that Italy will need the ECB to keep borrowing costs low or need some sort of debt restructuring that could include an exit from the euro. 

To be clear, a sovereign debt crisis isn’t the base case.  Recent ECB measures ensure that no country will lose market access. This eliminates the risk of a liquidity crisis leading to a solvency crisis; however, this doesn’t mean the risks aren’t there which puts a heavy weight on the ECB’s shoulders as it meets later this week.  Debt sustainability and euro cohesion are not binary events.  Expect the euro to continually adjust to reflect the changing probability of different outcomes which should bias the single currency towards weakness.        
  • The Australian dollar outperformed all of its Group-of-10 peers as easing coronavirus-related restrictions in two states spurred optimism that the outbreak was slowing in the nation.
  • The Fed, ECB and BoJ all meet this week as central banks remain under pressure to do more to support their economies through the COVID-19 driven recession.  Combined, the economies covered by these three central banks account for more than half of global output.
  • The BoJ met overnight and left its policy rate and 10-year yield target unchanged.  However, the BOJ did remove its QE limits and is moving to a “whatever is needed” policy.  As touched on in past commentaries, this appears to be more of a concession to the current situation than a shift in policy.  The Bank of Japan was already using a yield curve control policy which allowed it to buy whatever it needed to maintain its yield target.  The BoJ also ramped up its purchases of corporate debt and expanded its range of acceptable collateral which now includes, among other things, household debt.
  • Last Friday, Standard and Poor affirmed its BBB rating for Italy but maintained its negative outlook.  Moody’s is scheduled to review its rating for Italy on May 8.  Despite S&P’s recent affirmation, it seems to be just a matter of time before Italy loses its investment grade rating, but for now, Italian bonds are breathing a sigh of relief with 10-year yields continuing to move higher.
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