Drastic Action Needed

There has been no let up in pressure on eurozone markets and consequently risk aversion continues to increase. The failure of Ireland’s bailout package to stem the haemorrhaging in eurozone bond markets highlights the difficulties in finding in a lasting solution and worsening liquidity conditions in several eurozone bond markets highlights the urgency to act.

Indeed, if spreads continue to widen as they have since late October, by early to mid 2011, Portuguese, Spanish and Italian Euribor spreads would be higher than the EFSF loan spread. In the (admittedly extreme) case that sovereigns could not raise money in the market, peripherals would run out of money early in 2011. Policy makers will try to not let the situation get so out of hand but what can be done to stem the damage?

The European Central Bank (ECB) may be forced to delay its exit strategy by maintaining unlimited liquidity allotments to banks into next year and/or implement further liquidity support measures. The ECB meeting will be closely scrutinized for details, with ECB President Trichet having to adjust policy accordingly. A further option could be for the ECB to step up its bond buying programme which may provide some relief to peripheral eurozone bond markets and the EUR.

Whether this offers a lasting solution however, is debatable. The risk of action by the ECB tomorrow may fuel some caution in the market towards selling the EUR further in the short term and could even prompt some short EUR covering around the meeting which could see EUR/USD regain a sustainable hold above 1.3000 again but this may be temporary, offering better levels to sell.

Meanwhile, speculation of a break up of the eurozone into a core euro and a peripheral euro has intensified given the growing divergence in growth and competitiveness across the region. Such speculation looks far fetched. The eurozone project has been politically driven from the start and over the last 60 years or so internal economic strains have been papered over by politicians. The political will is likely to remain in place even if the divergence in fundamentals across Europe has continued to widen.

Bond market sentiment was not helped by the fact that S&P put Portugal’s ratings on creditwatch negative citing downward economic pressure and concerns over the government’s credit worthiness. Importantly S&P still expects Portugal to remain at investment grade if downgraded. Note that Portugal’s central bank highlighted that the country’s banking sector faced “intolerable” risk unless the government implements planned austerity measures.

In contrast the US story is looking increasingly positive, highlighting that the USD’s strength is not merely a reaction to EUR weakness but more likely inherent and broad improvement in USD sentiment. US consumer confidence, Chicago PMI and the Milwaukee PMI beat forecasts in November, continuing the trend of consensus beating data releases over recent weeks.
Although this does not change the outlook for quantitative easing (QE) as the Fed remains focused on core CPI and the unemployment rate, the data paints an encouraging picture of the economy.

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