Waiting for a solution to Europe’s crisis

The boost to sentiment following Germany’s approval of changes to the EFSF bailout fund was brief. Although the outcome of the vote was not particularly surprising political concerns were assuaged by the fact that Chancellor Merkel secured support from within her coalition. Markets were also helped by a bigger than expected drop in weekly US jobless claims but this also failed to provide a lasting impact.

The bottom line is that there is still a huge degree of scepticism on the ability of policymakers to resolve the crisis in the eurozone periphery while growth worries have not receded. Even the approved changed to the EFSF bailout fund are increasingly being seen as old news given the view that it will need deeper changes including ‘leveraging’ it up.

Consequently risk aversion remains at a highly elevated level and is showing no sign of easing. It may be difficult to turn sentiment around as we go into the final quarter of the year, especially as those investors registering profits for the year may want to capitalise on these profits rather than sit through continued volatility in the weeks ahead. Indeed the sharp drop in gold prices over the last couple of weeks even in an environment of elevated risk aversion may reflect this.

Similarly risk assets may struggle to recover over coming weeks unless there is a major improvement in the situation in Europe or in growth data. Markets will go into the end of this week looking ahead to key events next week including an Ecofin meeting at the beginning of next week, a European Central Bank (ECB) meeting and the US September jobs report.

There will be plenty of attention on the Ecofin meeting of European Finance Ministers on Monday especially given that much of the reason for the stability in markets recently is the hope of concrete measures to resolve the crisis in the region. In this respect the scope for disappointment is high, suggesting that the EUR is vulnerable to a further drop.

While the extent of short market positioning at the beginning of week left open some scope for EUR short covering the absence of any good news will mean the impetus for short covering diminishes. Unless the Ecofin meeting delivers on expectations EUR/USD will likely re-test the 26 September low around 1.3363.

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