Progress at last in Europe

As last week progressed markets had been increasingly poised for disappointment at the EU Summit at the end of the week. Given such low expectations it was probably not so difficult to exceed them. In the event there was progress towards breaking the vicious cycle between banks and sovereigns. The immediate reaction to the announcements from the EU President was clearly positive, with risk assets rallying sharply. EUR/USD had rallied by over 2 big figures from a low just above 1.24 as a massive short squeeze helped propel it higher.

With their backs against the wall EU leaders finally agreed upon short term stabilisation measures as well as long term measures towards closer European integration. Under pressure from other leaders including French President Hollande, German leader Merkel obviously softened her stance to agree on some of these measures. The deal goes to show that leaders in Europe can act when needed or at least when desperate which is how they were after 13 hours of talks and the reality that bond yields in Spain and Portugal were at unsustainable levels.

Short term measures in particular utilising the EFSF / ESM bailout fund to recapitalize banks directly and the creation of a European banking supervisory body was a shot in the arm for Italian and Spanish bonds and the EUR. The dropping of the condition that EU governments be given preferred creditor status for loans to Spanish banks bodes well for peripheral Eurozone sovereign debt markets as it means that private investors will not be put at the back of the que in any debt restructuring.

While the measures mark an important step in the direction of providing clear resolutions to the Eurozone crisis there is a very long way to go. Admitedly the use of the bailout funds is positive but at some point markets will ponder the fact that while they could handle a bailout of Spain the funds are clearly insufficient to cope with a bailout of Italy should it be needed. If the steps announced at the EU summit lead to a sustained drop in peripheral country bond yields then the prospects of more bailouts will be limited but this is by no means guaranteed.

Whether the risk rally is sustained into next week depends in part on whether the European Central Bank responds with actions of its own by cutting interest rates or by indicating the use of other measures such as restarting its securities markets purchases program. The risk remains that the rally will likely fade as skepticism sets in again once again and more details are sought.


USD and JPY remaining firm

The USD has rebounded since 19 June in the wake of growing uncertainties and potential disappointment emanating from the EU Summit. As I previously highlighted a rally in the USD was to be expected in the wake of an extension of Operation Twist.

Looking ahead, as Bernanke and Co. also left open the option of more quantitative easing the USD is not out of the woods yet. The USD’s path will not only depend on risk but also on upcoming data releases. A further run of weak data will once again raise the spectre of more QE potentially leading to a softer USD.

Today’s US releases are unlikely to lend support to QE expectations, however. A bounce in May durable goods orders is expected while pending home sales are likely to recoup some of the sharp drop registered in April. However, markets will have to wait until next week for the release of the most important indicator, the June jobs report, before a clearer USD direction emerges.

USD/JPY remains well and truly constrained below the 80.00 level. Elevated risk aversion and a decline in the US yield advantage over Japan are acting as a restraint to any upside move in USD/JPY. Moreover, I do not expect any impact on the JPY from the passage of a bill to raise the consumption tax. Evidence that the Japanese economy is recovering may explain the lack of official enthusiasm to weaken the JPY but this assessment is prone to disappointment.

Increasingly, JPY bears are becoming frustrated by the lack of JPY downside traction. This has been reflected in the turnaround in speculative sentiment which turned positive for the first time in 15 weeks. Going forward, it will be difficult for USD/JPY to rise much unless US yields move higher. Eventually I think this will happen and look for USD/JPY to end the year around 83.00

More bad news in Europe, INR not impressed by new measures

Nervousness or simply just impatience is growing ahead of the EU Summit beginning on Thursday. The formal application by Spain for a banking bailout of up to EUR 100 billion has started the process while Greece is looking to renegotiate the terms of its bailout following the formation of a new government in the country.

European equities are not reacting well, however, with sharp declines registered yesterday following by drops in US stocks. Risk assets have come under pressure as noted by the sharp 12.5% jump in the VIX index overnight while the USD index continued to strengthen.

Interestingly despite the rise in risk aversion, many high beta currencies are holding up reasonably well. Indeed, those with the biggest sensitivities to risk such as ZAR, MXN, PLN and EUR have failed to drop while implied currency volatility has been falling over recent weeks. This may reflect the beginning of summer trading conditions rather than resilience in currency markets but nonetheless, it suggests a dose of FX calm ahead of the EU summit.

EUR/USD came under pressure hitting a low around 1.2471 failed to extend losses. The bad news intensified and included the formal Spanish bank aid request, Moody’s downgrade of 28 Spanish banks’ ratings, Fitch’s decision to cut Cyprus’ ratings to junk status, lack of concessions from German Chancellor Merkel who maintained her strong stance against common Eurobonds and inflexibility about the use of rescue funds. As a result it looks increasingly unlikely that a concrete plan will emerge from this week’s EU summit. EUR/USD will find technical support around 1.2442 and resistance around 1.2584.

One currency that has failed to perk up is the Indian rupee. New measures announced yesterday to shore up the INR including a $5 billion increase in the foreign investment cap in government bonds and an increase in the limit for domestic firms to borrow from overseas of up to $40 billion, failed to have more than a fleeting impact on the currency.

What were missing were measures to increase exports and cut excise duties. The measures left markets who had expected much more, with a taste of disappointment. While the measures are a decent starting point clearly much more will need to be done to appease markets and reverse the gloom among INR bears.

Caution ahead of EU Summit

Risk appetite has continued to firm over the last few weeks although notably risk is still elevated compared to the the levels seen in May, suggesting that there is some way to go before risk appetite normalises. Improving risk appetite perhaps reflects rising expectations of a credible set of solutions to the Eurozone crisis but various summits and official meetings including the G20 meeting have failed to deliver anything of this nature.

Attention will turn to the EU Summit on 28-29 June where various issues ranging from debt mutualisation to fiscal and banking union as well as a potential renegotiation of Greece’s bailout terms, will be discussed. Markets are likely to remain relatively range bound ahead of the Summit.

There are also plenty of data releases to contend with over coming days including new home sales, consumer confidence and durable goods orders in the US as well as flash CPI inflation estimates, economic confidence gauges and Italian debt auctions in the Eurozone. Japan will release inflation data too and industrial production data.

On balance US data will continue to outperform although consumer confidence is likely to slip in June. In Europe, confidence indices will reveal some further deterioration in June, while in Japan weak industrial production and a drop in monthly inflation will maintain the pressure on policymakers to act in the country.

The USD will continue to find support from the fact that the Fed did not implement more quantitative easing but firmer risk appetite will cap the ability of the USD to strengthen much from current levels. It is notable that the USD long positions dropped sharply according to IMM data ahead of the Fed meeting but it is likely that Fed QE inaction will result in some rebuilding of USD longs.

In any case, given the uncertainty ahead of the EU Summit it is unlikely that the EUR will break out of its current ranges. Notably there was a major bout of EUR short covering last week, with EUR/USD shorts dropping sharply according to the IMM data. Hopes ahead of the EU Summit may encourage more short covering but as usual scope for disagreement and disappointment on many fronts, suggests that investors should not become overly bullish. EUR/USD will find some initial resistance around 1.2583 to any upside.

Chronology of a Crisis – endgame?

Please see below an extract from my forthcoming book Chronology of a Crisis (Searching Finance 2012).

The departure of Greece from the Euro is by no means a forgone conclusion but if it happens it is not clear that global policy makers have much ammunition left to shield markets from the resulting fallout.

Stimulus after stimulus has only left governments increasingly indebted. The price of such largesse is now being paid in the form of higher borrowing costs. Even central banks do not have much ammunition left. Admittedly further rounds of quantitative easing, and central bank balance sheet expansion may help to shore up confidence but the efficacy of such policy actions is questionable. Moreover, policy support may only help to buy time but if underlying structural issues are not resolved pressure could resume quickly.

Against this background Europe is under intense pressure and there is little time left before it results in something catastrophic for global markets via a disorderly break up of the Eurozone. EU leaders and the European Central Bank (ECB) have to act to stem the crisis. However, at the time of writing the ECB under the helm of Mario Draghi is steadfastly refusing to provide further assistance to the Eurozone periphery either directly via lower interest rates or securities market purchases or indirectly via another Long term refinancing operation (LTRO). Any prospect of debt monetization as carried out already by other central banks including the Fed and Bank of England is a definite non-starter. The reason for this intransigence is that the ECB does not want to let Eurozone governments off the hook, worrying that any further assistance would allow governments to slow or even renege upon promised reforms.

Whether this is true or not it’s a dangerous game to play. The fact that the previously unthinkable could happen ie a country could exit the Eurozone should have by now prompted some major action by European officials. Instead the ECB is unwilling to give ground while Germany continues to stand in the way of any move towards debt mutualisation in the form of a common Eurobond and/or other measures such as awarding a banking license to the EFSF bailout fund which would effectively allow it to help recapitalize banks and purchase peripheral debt. Germany does not want to allow peripheral countries to be let off the hook either, arguing that they would benefit from Germany’s strong credit standing and lower yields without paying the costs.

To be frank, it’s too late for such brinkmanship. The situation in The Eurozone is rapidly spiraling out of control. While both the ECB and Germany may have valid arguments the bottom line is that the situation could get far worse if officials fail to act. As noted above there are various measures that could be enacted. Admittedly many of these will only buy time rather than fix the many and varied structural problems afflicting a group of countries tied together by a single currency and monetary policy and separate fiscal policies but at the moment time is what is needed the most. Buying time will allow policymakers to enact reforms, enhance productivity, reform labour markets, increase investment funds etc. Unfortunately European policy makers do not appear to have grasped this fact. Now more than at any time during the crisis much depends on the actions of policy makers. This is where the major uncertainty lies.

If officials do not act to stem the crisis, economic and market turmoil will reach proportions exceeding that of even the Lehmans bust.

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