All Eyes On Europe

EUR looks range bound ahead of key events including the European Central Bank (ECB) meeting, European Union Summit and release of bank stress test results. A senior German official poured cold water over expectations of a concrete outcome from the EU Summit, dampening EUR sentiment as a result.

There will be plenty of attention on the ECB to determine whether they will give a little more ground and provide further assistance to the Eurozone periphery. While a refi policy rate cut is highly likely as well as additional liquidity measures I do not expect any move in the direction of more aggressive action to support peripheral bonds in terms of becoming “lender of the last resort’.

If however, the ECB hints at intensifying its securities market purchases of Eurozone bonds this will likely bode well for the EUR. Indeed, reports overnight suggest that the ECB will announce a set of measures to stimulate bank lending including easing collateral requirements for banks.

More weak UK data in the form a bigger than consensus drop in manufacturing and industrial production in October add to the soft BRC retail sales and house price data, in putting pressure on the Bank of England (BoE) to increase its quantitative easing at today’s policy meeting. While the BoE is set to keep policy unchanged it is only a matter of time before additional asset purchases are announced.

Despite the weaker IP data GBP has held up relatively well against the USD although downside risks appear to be intensifying. If I am correct in the view of no change by the BoE today we expect little change in GBP although there could be a risk of a push higher in EUR/GBP if the ECB delivers some positive news, with resistance seen around 0.8665.

The RBNZ unsurprisingly left policy rates unchanged at 2.5%, sounded less hawkish than the previous meeting and also lowered growth forecasts. The NZD was left unmoved by the rate decision and looks well supported at current levels perhaps due to relief that the statement was not more dovish. The kiwi has been an underperformer over the year but unlike the AUD it has not been particularly influenced by gyrations in risk aversion.

Interest rate futures differentials have seen a renewed widening versus the US over recent weeks. This is significant given that the NZ-US interest rate differentials have a very strong correlation with the performance of NZD/USD. If this widening is sustained it will point to upside potential for the Kiwi.

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The Italian Job

Italy looks too big to rescue yet is too big to fail. The country has around EUR 1.9 trillion in public debt (around 5 times that of Greece) and is the third largest country in the eurozone. Therefore it cannot be as easily dealt with as Greece.

Italy needs to raise around EUR 18 billion per month to cover its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable. Higher collateral haircuts on Italian debt are adding to the pressure.

Although Italian Prime Minister Berlusconi has said he will step down in the wake of reform measures to be voted on by the Italian parliament the vote on the measures may not take place for weeks. Moreover, Berlusconi may attempt to seek re-election after stepping down, which could bring the situation back to square one.

In the meantime speculation that Italy may be the next country to need to a bailout will intensify. However, with only around EUR 270 billion remaining in the EFSF bailout fund and details of how the fund will be leveraged to a planned EUR 1 trillion still lacking, doubts about whether it will have sufficient resources will grow. Press reports that Germany and France have begun talks to break up the eurozone due to fears that Italy will be too big to rescue will only add to the malaise.

Focus over the short term will turn to today’s 12 month auction of EUR 5 billion in Italy. Last month’s 12 month auction saw an average yield of 3.57% but this time around yields could rise above 6%. Worryingly it appears that even with the European Central Bank (ECB) buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s reluctance to become lender of the last resort to European peripherals, any support from this direction will be limited. Against this background the EUR remains highly vulnerable to a further drop. Indeed, the EUR’s recent resilience looks all the more misplaced. A test of the 4 October low around EUR/USD 1.3146 is on the cards over coming days.

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