Spain banks may throw spanner into euro rally

Investors have yet to price in the cost of re-capitalising Spanish banks, and this could see the euro pull back from 15-month highs against the dollar, though a test of $1.50 within the next few months is still on the cards.
The euro hit $1.4521 this week, its highest since January 2010, and is up 8 percent so far this year as Asian central banks diversify out of the US dollar into the single currency and investors price in more monetary tightening by the European Central Bank (ECB) in the coming months.
Analysts say the currency market is underestimating the cost of re-capitalising Spain's troubled banking sector and the associated risk of contagion, with many fixated on interest rate differentials between the eurozone, the US and Japan.
This week talk of a possible restructuring of Greek debt and a Moody's warning about Ireland's fiscal outlook brought the euro zone's unresolved crisis back into focus.
"If the Spanish funding situation deteriorates significantly in part on the back of intensifying contagion from Greece and Portugal and in part on the back of more losses in the Spanish banking sector, we could see the euro easing well below its recent highs," said Valentin Marinov, forex strategist at Citi.
"But as long as that does not happen, any correction in the euro is likely to be fairly muted as we will see buying by sovereign names at lower levels."
Spanish regional banks - or cajas - which are at the heart of its problem after taking on too much risk during the country's real estate bubble need at least 15 billion euros ($10.4 billion) of fresh capital, according to the government.
That is fairly conservative with some analysts estimating the shortfall at as high as 120 billion euros when future losses related to real estate writedowns are included and as ECB rate hikes add to more losses to their mortgage portfolios.
"The need for considerable further retrenchment in the Spanish state as well as in the domestic banking system carries significant negative implications," said Lena Komileva, global head of G-10 strategy at Brown Brothers Harriman. "Spain's fundamental-policy mix carries the persistent risk of another, much more damaging debt crisis in the euro area."