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Citi’s currency guru Steve Englander asks 2 great questions:1) What if they do the big bazooka approach –a blanket guarantee on peripheral bonds, concentrated and aggressive buying by the ECB of euro zone debt or some sort of announcement on euro bonds? Investors still seem to be trading off tail risk, so it is likely that if one of these ‘big’ solutions is adopted, we would see the EUR rally initially and perhaps sharply on the reduction of the tail blowup risk. At this stage the question would be whether such proposals would be credible if Italy and Spain were under sustained pressure, since the potential sums would be extremely large and political opposition in the core far from trivial. The longer term is whether this type on ongoing support for the peripheral countries is supportive for the EUR — insofar as the lid could be closed on Italy and Spain, the costs of the smaller peripherals may not be large relative to the size but it is unlikely that investors would see bailouts beyond the small peripherals as feasible.
2) How much contagion beyond the EUR? The eurozone banks index is basically where it was at the beginning of 2009 and below its worst level of 2010. The good news is that the crisis has been festering long enough that policymakers in G10 and smaller G10 countries have had a chance to prepare for a severe crisis emanating from Europe, either through contraction of bank balance sheets or directly from sovereign debt. An uncontrolled euro zone debt crisis could potentially be another Lehman’s event but there has been more and more opportunity both for positions to be cut and policy measures to be prepared. Hence, it may be that the spillover effects onto risk-correlated currencies will be concentrated in short periods of acute risk-aversion. Especially EM reserve managers with portfolios about 85% EUR and USD in aggregate, will be happy to buy alternatives on any pullback, provided that they do not see big long-term deterioration in their own prospects.