How Bad Is the European Debt Situation? Will It Drown the Economy or Sink the Euro?

Given last week's break of 1.4000 by the euro as the focus on the Greek debt situation continues, I thought it would be good to take a deeper dive into where the different countries that make up the euro stand.

First, the S&P risk ratings of countries in the euro are:

Looking at these ratings, Greece's position among the euro countries is clear. Last week Greece issued a 10-year bond that was oversubscribed, only after they raised the interest rate 0.3 percent. This made it a little more expensive for the Greek government to fund their debt. Since the auction, the bonds have fallen in value to a yield of 6.86 percent — 4.05 percent above German 10-year bonds. A spread of this magnitude has not occurred previously between euro countries and is the kind of differential that gets economists and analysts discussing how a basket currency like the euro can endure this kind of internal pressure. After all, it would appear that Greek bonds would be more attractive than the lower-yielding German bonds that have the same currency risk. In practice though, it is a moot point because this is a clear case where higher yield may not be attractive to investors. The risks are clearly so high Greek bonds may not attract funds from other euro-based government bonds, making it a non-issue for now. But what happens in the future when Greece gets its act together? Again, this is not an issue because the Greek bonds should rally, reducing the yield. This sets up an arbitrage situation for those who trade euro-based bonds, and as long as things don't get too far out of whack (financial market jargon), internal pressures of the euro-based government bond markets will not build up enough to disrupt the currency. Having said this or other similar circumstances are not enough to break the euro apart, there could be other less serious repercussions.

Greece is not the only country in the euro zone that has debt problems as can be seen from the debt ratings which are not perfect, but do provide a good indication at a glance of where problems lie. What ratings don't show are news bites, such as S&P firing a warning shot across the UK's bow over concerns about the health of the British banking system last week.

Ireland, for example, has taken a hard-line approach and cut public sector salaries by between 5 and 15 percent. Portugal and Spain are scheduled to publish new budgets in the next month. Given the amount of scrutiny the euro zone is under, the content of these budgets could add to the negative sentiment that is building against the euro if they are viewed as not being substantial enough. Questions about the viability of Greece's budget, which is already known, and the sell-off in the newly issued bonds tell us how much credence the markets had in their proposal. More of the same from Portugal and Spain will undoubtedly push the euro lower.

I find it interesting that by creating the European Union and the euro, the Europeans have created a structure that at some time inevitably would create its own problem of systemic risk for the member countries and others (like Switzerland) in the region.

We also have to look at the U.S. economy and how it is likely to compare to the European economy. If we take an unscientific snapshot, last week's euro data had unemployment rising to 10 percent, while U.S. GDP for Q4 jumped to 5.7 percent, far higher than expected. Today's National Manufacturing Index rose to 58.4 from 55.5 in January (a reading above 50 signifies growth). Recent European data is lagging the U.S.

The technical analysis is interesting. The euro broke down through the 200-day moving average line on January 20 when it was at 1.4290. The last time the line was crossed and there was a trend change was on May 7, 2009, which shows what a long-term indicator this can be. The 200-day support line had been touched three times since December 22, 2009, but held as support until the break. On Friday the euro finished right on the old support at 1.3856 from June 15, 2009. With this level breaking this morning, the next support is at 1.3424 from May 18, 2009, setting up a potential drop to this level that would not be out of the question. Going back to economic fundamentals, this week we get the unemployment data on Friday. A good number might provide the momentum for the US$ to push the euro down further. The trend, at this point, makes a weaker euro more likely than not.