June Is “Make or Break” for Eurozone

06/02/2011 5:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Two major events are coming this June that will certainly drive price action in the euro. Meanwhile, the Swiss National Bank has come under recent pressure to raise rates.

As we begin a new month, it is worth taking stock of what lies ahead of us, especially since June is set to be a critical month for the European currency bloc. 

Firstly, the results of the latest round of stress tests on Europe’s banks are set to be released. This is expected to be the most stringent round yet (we’ve heard that before!) and is designed to reveal the true depth of Europe’s banking crisis so that capital bases can be re-built and investors can have confidence investing in Europe’s financial institutions once more.

The major risk from the stress tests is Spain. If its troubled domestic lenders—the Caja banks—have more bad debts than expected, the government will be under pressure to underwrite the capital shortfall, akin to what Ireland did to eventually force that country into a bailout.

Currently, analysts estimate that losses for Spain’s banking sector could be as high as EUR120 billion, which is almost ten times the Spanish Central Bank’s projection. Massive loans to property developers are the bulk of the toxic assets on the Caja balance sheets. These may top EUR300 billion as Spain’s property market remains in deep trouble.

A bailout of Spain is too big for the current European Financial Stability Facility (EFSF) to manage and would therefore threaten the stability of the Eurozone. Nerves are likely to be on edge prior to the release of the tests. The exact date the results are due is not yet known, but some in the market predict they will come out in June or July, so watch out!

Also due are the results of the International Monetary Fund (IMF) audit of Greece’s compliance with deficit-reduction targets, which is expected sometime before the end of June and possibly as soon as next week.

There are concerns that Athens will not have complied with the terms of its bailout loan, so the world’s lender of last resort will cut its support to the nation. This would make a default of Greece extremely likely and could see another wave of panic wash over the financial markets.

This is likely to keep the euro capped in a range until these “unknowns” are finally known. So watch out for some sharp moves, especially if Spain’s banking crisis is worse than first thought. Below the 1.4040 level, EUR/USD is in a technical downtrend.

NEXT: There’s More Than Meets the Eye for Swiss Franc

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There’s More Than Meets the Eye for Swiss Franc

The Swiss franc (CHF) had a storming week, breaking fresh highs versus the euro, and it is now on the cusp of all-time highs against the British pound. It’s no surprise that the Swissie was stronger last week, as the markets remained jittery about developments in the sovereign debt crisis and the prospects that the IMF may not extend more bailout funds to Greece next month. 

But as risky assets came more into favor at the end of last week, the Swissie remained in demand. This suggests that there are more than just safe-haven flows driving the franc.

Of course, investors remain nervous about the sovereign debt crisis, which should keep the Swissie well supported, but at the same time, a raft of strong economic data, along with its own warning from the IMF suggest that domestic fundamentals could be a key driver of the currency going forward.

At the end of last week, the IMF explicitly called for the Swiss National Bank (SNB) to hike interest rates in the “near term” in a report. It called the current policy of remaining on hold “unsustainable” and said that fears a strong franc would cause deflation or weigh on exports were unjustified.

The latter point was backed up by exports data for April, which showed a 7.9% increase, easily reversing the 3.1% decline in March and suggesting that a high franc hasn’t yet dampened demand for Swiss goods.

This wasn’t the only bit of good economic news. The KOF survey, a popular leading economic indicator, also remained at an elevated level in May.

So now the pressure is being heaped on the SNB to change its policy stance, which has consisted of keeping rates on hold and talking down the currency. The IMF said that intervention in the markets (verbal or direct) should only occur if there is excessive volatility, which isn’t the case right now.

So the SNB may have no choice but to hike rates in order to retain their credibility. The next policy meeting is June 16, and so far, the markets still think that rates will remain on hold at 0.25%, but GDP data released on May 31 could make this position untenable.

Although inflation is not currently a problem—in April, it was a mere 0.3% on an annualized basis— high levels of growth—the markets expect a 3% year-over-year rate—could lead to inflation pressures building up in the future.

By Brian Dolan, chief currency strategist, FOREX.com

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