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Spain Contagion Fears Weigh on Euro

NEW YORK ( TheStreet) - U.S. dollar was firmer vs. the majors, with EUR/USD so far unable to climb above 1.2350. Widening peripheral bond spreads are likely to become a bigger issue, with Spain the latest to succumb to contagion fears. We think the current euro correction could go as high as 1.25, but we continue to view this move as a correction, not a trend change.

There have been several press reports in recent days, all vehemently denied, that a multilateral effort is underway to put together a special aid package for Spain. Often times, one hears "where there is smoke, there is fire." Yet in this case, the denials look credible. The European Financial Stabilization Facility (EFSF) which is the lion's share of the €750 billion package, is only coming into effect at the end of the month.

Newswires report that Germany has acknowledged that 90% of the funding has been secured and this is the threshold needed to make the facility operative. Other details of the EFSF have been reported. Apparently the EFSF is considering issuing foreign currency bonds that could be hedged in the swap market for example. One important implication is that this foreign currency borrowing would underscore the ECB and German point that 1) it is not the beginning of a European bond market, and 2) it is temporary in nature.

Just because there is not a special Spanish funding program does not mean that officials are not concerned about Spain. Spanish banks borrowed a record amount from the ECB last month and the CEO of BBVA noted earlier this week that many Spanish banks and corporates are being frozen out of the capital markets. The premium that Spain is being forced to pay over Germany for 10-year money is at the widest since the advent of the euro. The 2-year spread is the widest in nearly two years.

This means that the existence of the EFSF has not stabilized the Spanish bond market. The IMF's Strauss-Kahn is visiting Spain at the end of the week and, although promoted as a normal visit, it is bound to get the chins wagging about the need for assistance. Thursday will see a test of the market's appetite for Spanish bonds. The government plans on selling about €3.5 billion of 2020 and 2041 stock. While the former is bound to be challenging enough, it is the latter that may be most troublesome.

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