The markets have been much more anaemic today after the excitement of Friday and Monday’s sessions, however, the same stresses and strains continue to be the dominant factor moving market, which leaves risky assets vulnerable to another break to the downside.

Europe remains front and centre, in particular Spain, and there was no let-up today. The chief concern is whether or not Europe, the IMF and the ECB can afford to bail out Spain, and maybe even Italy.  It is still unknown whether or not the Eurozone could survive if its fourth largest economy collapsed, and this is likely to weigh on markets for some time. In fact some people are surprised by the resilience of the euro in the face of Spanish bond yields rising to fresh euro-era highs. We put down some of this resilience to the unwinding of euro-funded carry trades as traders turn risk averse.

Spain – could a Spexit be on the cards too?

At the start of this year Spanish yields were below 5% (post the LTRO), now they are a touch below 7.6%. This is an unsustainable cost for Spain unless the country drastically reduces its borrowings in the coming years. Hence the Telegraph reported earlier that Spain may consider leaving the currency bloc in order to regain competitiveness through a devalued currency and to gain control of its economy and budget. The markets have got used to the idea of a Grexit, but a Spexit is definitely not priced in by the markets. In that scenario we could see Spain’s yield curve move deeply into inverted territory (which highlights severe sovereign stress) and the euro fall much sharply than it has to date.

However, today the market is not focusing on the practicalities of that scenario and Spain’s departure from the currency bloc remains at the back of the markets’ minds. Hence the euro managed to rally yesterday after reaching a low just below 1.2070. That is now key support ahead of the major 1.20 level. This is psychologically important as it could signal even deeper declines compared with June 2010 during the first Greek crisis. Since then we have had private sector debt haircuts and Spain has been dragged into the fray, thus the fundamental basis for deeper declines towards 1.15 seems to be intact.

Germany’s economy shows fault lines

The flash reading of the Eurozone’s PMI for July was released this morning and it made for grim reading. Although the data was roughly in line with expectations, it remains below the crucial 50 mark, which suggests further contraction for the currency bloc’s economy in the third quarter. What is more worrying is that Germany’s service sector PMI dipped below 50 for the first time since September last year. This is concerning since the domestic sector has helped to boost Germany’s economy so far, and if it starts to weaken then Germany’s economic prospects will start to darken, essentially giving traders another reason to sell the euro and euro-based assets.

The Aussie: handle with caution

Other big movers today included the Aussie. It managed to remain fairly resilient overnight as China’s PMI data was stronger than expected. However, it faltered around 1.03 as the Eurozone crisis started to dampen spirits once more. It is testing key support at 1.0280 – the 200-day sma. This is an important level for this pair as a move below here could see a re-test of 1.02 (the 100-dday sma) then 1.0150. Above may see investors’ take another stab at 1.0380 and then 1.0430 – the double top from earlier this month. Overall, although the Aussie remains attractive from a yield perspective investors are likely to treat this currency with caution and expect selling interest after rallies as the Aussie remains sensitive to overall market risk, which is dominated by Europe at the moment.

Ahead today there isn’t much economic data to occupy the markets’ minds. Instead the focus will be on the troika meeting in Greece and then the meeting between German and Spanish finance ministers later today.

One to watch:

We continue to see the EURUSD as a sell on rallies. Any move towards 1.2140 may be sold aggressively and we would look for an initial break of 1.20 in the coming days. This is primarily due to the incessant pressure on Spain. Its 5-year yield is nearly at the same level as the 10- year as you can see in the chart below. When a rate spread chart looks like this it suggests a couple of things: 1, the credit market is unhealthy 2, the markets believe the short term chance of getting their money back is deteriorating, hence why the short term yield is above the longer-term yield. This is not euro supportive, and we believe the single currency could fall further in the short term.

Spain 10-year – 5-year yield spread

PLEASE NOTE THIS IS A BLOOMBERG CHART AND IT SHOWS PRODUCTS THAT ARE NOT OFFERED BT FOREX.COM

Best Regards,

Kathleen Brooks