Given the deterioration left, right, and center in Europe's core and peripheral economies, some question the sustained 'strength' of EURUSD. An under-the-table peg around 1.27 is the conspiracy chatter but we fall back to a tried-and-true recipe for comprehending what the market is thinking - the central banks are in charge and the EURUSD exchange rate merely reflects (as a main trend) the relationship between those two balance sheets (as monetary policy escalates downwards and they battle each other to 'defend' their own currencies' demise).
To wit, given the current ratio of the Fed and ECB balance sheets, we would expect EURUSD to be trading around 1.21. However, we know that the Fed will be adding $1.17tn to its balance sheet thanks to QE3 (and its inevitable QE4 extension to cover for Twist's expiration). The current ratio of Fed/ECB balance sheets is 0.95x, with the addition of the $1.17tn expected (to just over $4tn), the ratio rises to 1.33x.
The current EURUSD rate implies a balance-sheet ratio of 1.08x (see chart above) - which therefore means the market expects the ECB to expand its balance sheet by EUR740bn; this just happens to be the sum-total of Spanish sovereign debt (according to Bloomberg below - while our estimate is considerably higher).
So it seems, the market knows that once the ECB starts, it will not be able to stop and will end up taking the entire Spanish debt load onto its books.
Spain can perhaps deal with its existing debt in this way - but this appears to us merely incremental sustainability - and like in the US where the Fed is monetizing all long-dated Gross issuance, so the ECB will have no choice but to do the same with Spain in 2013 and 2014 - Treaty or no Treaty!!