It's Greek to Me

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. 

Over the past few months we have witnessed the euro soar higher. The 17-nation currency had appreciated from last year's low of $1.1850 in June and rose near 1.50 on May 4, the strongest since December 2009. The main catalyst appeared to be higher interest rate expectations for the European countries. The economies in many of the EU countries are expanding, providing a sense the worst had passed. In addition, European Union leaders likely viewed the EUR strength was "a vote of confidence in the euro" and in their efforts to contain the region's sovereign debt crisis. The rescue packages for Greece, Ireland and Portugal were allowing investors to cast aside worries over some euro zone nations and allowed focus on economic growth and interest rates. Over these past few weeks, there has been a reversal of fortune. Worries about debt troubles in the euro zone's peripheral economies have pushed the euro more than 9 cents, trading to near 1.40 last week. In addition, media reports — later denied by European policymakers — indicated that Greece may be considering exiting the euro. Such reports only highlight the concerns about how to best free the country from its debt mess.

Credit Rating  

The latest worries have, at least temporarily, brought debt issues again into the forefront. Greece's credit rating was cut to B from BB- by Standard and Poor's, which said further reductions are possible, putting private investors at risk if maturities are allowed to be extended on the nation's emergency aid package. Another rating cut would make Greece the lowest-rated country in Europe as S&P's latest move left it on par with Belarus. It was the fourth reduction by S&P since April 2010. Concern that Greece will restructure its debt has caused investors to demand more than 12 percentage points in yield to invest in the Greek 10-year note over the German bunds of similar maturity. The 2-year Greek bond is now yielding over 26 percent, up from 25 percent after the unions held walkouts last week. Greece could receive new aid as early as June to help it meet funding requirements. The problem is that financial markets have stopped believing any official announcement on Greek finances. Without any restructuring of Greek debt, the threat has turned the bailouts into a bottomless pit that could ultimately also affect the stronger euro zone nations. With such uncertainty, some expect the euro to slide further.

Opposing Forces 

Another cause for the recent EUR demise was a slight change in the interest rate outlook. As the EUR had risen in value, the talk from European financial leaders was the growing concern about inflation. At the latest ECB council meeting, interest rates were left unchanged. To the market's surprise, the ECB comments also signaled no rate hike in June as many expected, which pushed bund futures higher, and the euro lower. However, the central bank is still stressing that the risk of inflation is increasing .It is believed further hikes are in the pipeline, but perhaps at a slower pace. ECB officials have suggested that the central bank will make the decision based on updated data. If the latest growth numbers are any indication, a rate hike in July seems likely. Overall, euro zone GDP accelerated more than expected. The acceleration was driven by 1.5 percent quarter-on-quarter growth in Germany and 1.0 percent growth in France. ECB President Trichet repeated that economic data since the last ECB meeting confirmed that the "adjustment of the current very accommodative monetary policy was warranted." The ECB continues to see upward pressure on overall inflation. The central bank stressed that it is essential that "recent price developments do not give rise to broad based inflationary pressures" and that inflation expectations remain firm.

Little Certainty 

"The only thing that seems 100 percent certain is that Greece remains mired in debt and that at least a good portion of that debt is at risk of not being repaid should the situation not change considerably, both in terms of the financial metrics and spending levels within the country itself," said a market analyst. Thus, the EUR is vulnerable to growing worries despite the focused on the longer-term outlook for higher rates in the euro zone compared with the United States. Euro zone inflation had pushed the ECB's hand in raising key rates, but the sovereign debt problems in the region's periphery spreading to the region's larger economies has halted some optimism over future rate rises. The EUR can only be as strong as its weakest link. Oh and by the way, I wonder how the German taxpayers feel about bailing out Greece. Expect more volatility ahead.