Risk Aversion Back As Markets Reassess Spanish Bailout, Greek Elections

Markets are back in risk averse mode as Spain's banking bailout was reassessed by investors after risk rally. Fitch also downgraded two of Spain's biggest banks as the economic outlook worsened. Cyprus, another eurozone country, hinted yesterday that it may need to apply for an international bailout by month's end. Reuters reported that eurozone officials have discussed the possibility of imposing capital control on Greece exit. All the negative news sent US stocks lower overnight and dragged Asian equities into negative territories. EUR/USD is back trading below 1.25 for the moment while yen is back below 100. The weekly gap open in EUR/USD now look more like a bull trap than anything.

Optimism over the eurozone situation was over as the market well understood that the Spanish bailout is just a temporary pain killer but not a solution of the debt problems. As not much detail was unveiled over the weekend, the market began to speculate how the debt-ridden Spain would be financed. There have been speculations on whether the bailout will be financed by the ESM or EFSF. An "EU official" suggested that the EFSF was preferred to avoid the ESM's preferred creditor problem while a spokesperson for the German Finance Minister said that the ESM was more likely to be chosen.

Fitch downgraded Santander and BBVA to BBB+ from A, with negative outlook, yesterday. Both are just three levels above junk. Fitch noted that downgrades "reflect similar concerns to those that have affected the Spanish sovereign rating, in particular, that Spain is forecasted to remain in recession through the remainder of this year and 2013 compared to the previous expectation that the economy would benefit from a mild recovery." That's less than a week after Fitch slashed Spain's sovereign credit rating by three notches to BBB.

Reuters reported that a number of contingency plans were discussed among EU officials, including capital control, limiting size of ATM withdrawals, border checks. Sources said that the discussions are among finance experts that prepared for the worst-case scenario and the Bank of Greece is unaware of those plans. The idea of suspending the Schengen agreement for visa-free travel inside most EU countries was also discussed. Greece will have new elections this Sunday on June 17. So far, no party is having a runaway lead in polls. A Greece exit would be very near if the anti-austerity Syriza wins the election. But even if the pro-bailout New Democracy wins, the situation could just repeat itself if a coalition government is not formed.

Cyprus Finance Minister Vassos Shiarly said yesterday that recapitalization of banks in the country is "urgent" and time is pressing. It was reported last week that Cyprus will need to pump EUR 1.8b into its banks before end of June, as they're heavily exposed to Greek bonds. Shiarly said there is no final decision made on seeking regional assistance yet but noted that needs "may arise in the coming period." He warned that a Greece exit would "gravely" affect Cyprus. And the request could be a "comprehensive" package covering "present circumstances," "recapitalization of banks" and "future needs."

In US, Atlanta Fed President Lockhart stated in a speech in Chicago that no "options should be taken off the table under the current circumstances" and he was "convinced at this moment that the circumstances quite yet call for additional action." On the growth outlook, Lockhart forecast "the recovery process to be slow and drawn out." He believed the growth outlook would "moderate," with "a slow and possibly halting decline of unemployment, with inflation staying close to 2%."

Elsewhere, IMF warned that yen has "appreciated over the past year partly because of safe-haven capital inflows" and yen is "moderately overvalued from a medium-term perspective." IMF said Japan's asset purchase program could be expanded "substantially" to increase the chance of meeting the 1% inflation target by end of 2013. And, "an upfront announcement of such easing could also raise inflation expectations."

On the data front, UK RICS house price balance improved to -16 in May. Japan tertiary industry index dropped -0.3 %mom in April while domestic CGPI dropped -0.5% yoy. Australia NAB business confidence dropped to -2 in May. UK industrial and manufacturing productions will be released later today. US import price index will also be featured.