Portugal Weighs On The Euro

A political crisis in Portugal threatens to steal the region's lightening rod from Greece which has a few days to meet the latest the terms of the next aid tranche.

This was seized upon by the euro bears who appeared to need the added incentive to push the euro convincingly through the $1.30 level. In early North American activity yesterday, the market had succeeded in pushing the euro below $1.30, but it quickly snapped back and traded as high as $1.3040 before falling out of favor.

The euro traded on both sides of Monday's trading range and finished the North American session below Monday's low. Technically this is a bearish outside down day that seems to have ended the 4-5 day consolidative phase. Although we did expect the break to come when it did, we continue to suggest the $1.2850 near-term target.

The Portuguese story is fairly straightforward. The government's austerity in the face of continued contraction and high levels of unemployment has cost it public support. Finance Minister Gaspar, the architect of the austerity program, resigned. Having served as a director of research for the ECB (1998-2004), Gaspar was well connected and well liked in the halls of Brussels and Frankfurt, but in some ways it is surprising he lasted this long.

Not only were significant sacrifices made in the name of reaching budget deficit targets, but they were consistently missed. Moreover, the Troika has moved away from the emphasis on austerity, with the IMF acknowledging months ago that it under-estimated the fiscal multiplier.

Prime Minister Coelho named Maria Luis Albuquerque to replace Gaspar. She is very much in Gaspar's mold and may arguably the closest candidate to preserve continuity. Therein lies the problem. This triggered the resignation of the leader of the junior member of the coalition, Paulo Portas, who held the foreign ministry portfolio.

Initial news reports suggested that Coelho did not accept Portas resignation. The situation is fluid, but a collapse of the government is not a foregone conclusion. The conservative CDS, which Portas leads, may be able to eke out additional concessions for its continued support. The CDS has much to lose in an election. The latest polls show the opposition Socialists are ahead 36.9% to 24.9% for the Coelho's Social Democrats and 7.7% for the CDS.

Portugal is among the euro area countries most vulnerable to a rise in global interest rates, as it is projected to exit the assistance program in mid-2014. The rise in global yields coupled with country-specific risks have seen Portugal's 10-year benchmark yield rise 102 bp over the past month (compared with 20-30 bp in Spain and Italy). The benchmark 2-year yield has risen 64 bp in the same time.

Meanwhile, the Greek efforts to appease its official creditors will go to the wire, as has been often the case. The real deadline is not end of the week, but really the Eurogroup meeting of finance ministers next week. Just as party discipline saw some members of the New Democracy lose their standing, Prime Minister Samaras welcomed a few members back into the fold and this may give the government some more breathing room. We suspect--though no officials can admit to it--that additional concessions by the official sector (OSI) will ultimately be needed.