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This time two years ago if Spain's bond yields had risen to a record euro-era high then we may have seen EURUSD tumble sharply, potentially even below the 1.18 level reached in June 2010. However, Spain's bond yields surged above 6.8% (perilously close to the 7% level that triggered bailouts for Greece, Ireland and Portugal) and yet EURUSD is actually recovering after dipping below 1.2450 on Monday.

Waiting for the Greek elections


So why the recovery in the euro and can it last? We believe the recovery in the euro is being driven by expectations that 1, Greece will vote for a pro-bailout party at this Sunday's election and 2, that the European authorities will step in with Eurobonds/ more ECB support if Italy gets in more trouble and sees its bond yields surge to unsustainable levels. This has helped to keep volatility levels depressed (as measured by the Vix and the FX options market), which has helped markets to recover after Monday's sell off.

Will it last? This question is harder to answer. There is a good chance of a major relief rally post the Greek election if the Greek people vote for a pro-bailout party as it may erase the tail risk that Greece will leave the currency bloc in a disorderly way. Remember, the markets love certainty so if the currency bloc is more likely to stay as it is with all of its current members in toe that is good news for risk appetite. However, if Greece votes for an anti-bailout radical party this Sunday then we could easily see a bout of risk aversion and a spike higher in volatility, that could cause EURUSD to tumble back towards the 1.2350 lows from two weeks ago and potentially even make a stab at the 2010 1.20 lows.

Can the fragile optimism last?


Right now we don't know the result and Greece doesn't allow pre-election polling so the markets are consolidating and could even breach some short-term resistance levels. Above 1.2530 in EURUSD could open the way to 1.2570 then 1.2625 - the double top from last week and a major resistance zone. Not even the Italian bond auction could disrupt the recovery rally. Rome managed to sell its EU 6.5bn allotment of 1-year debt, although yields were up sharply to 3.9% vs. 2.3% at an auction a month ago. This is a very high price to pay for 1-year debt, and with a debt-to-GDP level of 120% and little economic growth expected, it's hard to see how yields at this level are affordable for Italy in the long-term. However, the market is only concerned about the short-term right now, and today it is looking like the glass is half full even if the longer-term outlook is fairly bleak.

Economic data is taking a back-seat today although a decline in oil prices continues to take the pressure off German inflation (it remained steady at 2.2% in May). Industrial production data was not as weak as expected in the currency bloc, falling 0.8% in April, less than the 1.2% decline expected. The annual rate of decline was 2.3%.

Don't dismiss headline risk


But headline risk remains an issue that could disrupt the current recovery rally. There are rumours of bank deposit withdrawals in Greece of EU 500-800mln in recent days. The risk is that the election result is perceived as negative forcing Greece to leave the Eurozone and causing the Greek people to panic and withdraw their cash from the banks all at the same time. Markets hate these types of bank runs and it could cause a massive blow to confidence. Thus, the levels of bank deposits in Greece are likely to be scrutinised in the coming days. If there is any concern that deposit withdrawals are turning into a torrent then we could see EURUSD, European stocks, commodities and risky FX take a dive lower.

Tomorrow German Chancellor Merkel addresses her Parliament on the G-20 objectives discussed 2 weeks ago. This could touch on the idea of Eurobonds. For this risk rally to continue for the medium-to-long term then we believe that we would need to see a softening of the German stance towards Eurobonds and a pooling of debt to try and reduce credit risks in Italy and Spain. In the absence of bad news, markets are happy to recover in the short-term.

Market Moves:


EURUSD, AUDUSD, GBPUSD have been in consolidation mode so far today and are testing the top of these s/t triangles suggesting that the recovery rally could have further to go. We have discussed EURUSD above; GBPUSD needs to get above 1.5570 to extend the rally to 1.5620 - a key resistance zone. Support lies at 1.5540 first and then 1.5460.

AUDUSD has had a strong recovery, as one would expect when risk returns to the market. There had been offers at 0.9970, but it seems to have cleared this hurdle leaving the way for a re-test of parity and 1.0025/30. The typical risk-sensitive assets like commodities, European banks and euro-stocks are also recovering today. However, they remain vulnerable to headline risk and also to movements in peripheral bond markets. Yields on Spanish and Italian bonds have retreated today, but they remain in critical territory. We would classify the price action so far today as fragile optimism, so keep your stops fairly tight and be nimble if the market winds change.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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