German election results help the euro

St Louis Fed President Bullard put a dampener on the market’s euphoria in the wake of the Fed’s postponed ‘tapering’ announcement. He noted that the Fed’s decision was “borderline”, implying that the Fed was not far from pulling the trigger to the commencement of tapering. Going forward, the timing of tapering will be highly data dependent and obviously recent weaker data releases and possibly the political complications surrounding extending the debt ceiling and agreeing on a budget, played heavily on the Fed’s conscience. However, there are now plenty of questions about the Fed’s communication strategy. There will plenty of Fed speeches over coming days to provide more clarity although Janet Yellen, front runner to succeed Ben Bernanke as Fed Chairman, appears to be keeping conspicuously quiet.

A bounce in China’s September manufacturing confidence revealed this morning as well as a strong outcome in the German elections for Chancellor Merkel (see below) will nonetheless, help to settle some market nerves as the week commences. Merkel’s CDU/CSU party is set to win close to 42% of the vote, which amounts to a very strong mandate. Nonetheless, she will still fall short of an absolute majority while Merkel’s coalition partner the FDP failed to gain enough votes to pass the 5% threshold to win any parliamentary seats means that a new coalition government will need to be formed. The EUR has reacted well to the result, remaining above 1.3500 versus the USD and looks to set consolidate gains over the short term.

Aside from various Fed speakers there will be several data releases to digest over the week. In the US there will be September consumer confidence, August durable goods orders, new home sales, personal income and spending, and revised Q2 GDP data on tap. Overall US data will be reasonably good, with in particular GDP set to be revised higher. In Europe, aside from digesting the German election result there will be a host of business and manufacturing surveys including the German IFO business confidence survey. Consolidation or moderate improvement is expected to be revealed in these surveys, likely giving sufficient support for the EUR to maintain recent gains.

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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.

More Bad News In Europe

Several pieces of bad news soured sentiment at the end of last week undoing much of the good news since the beginning of the year and dashing hopes of a relatively swift resolution to Eurozone’s ills. S&P ratings agency downgraded nine Eurozone countries’ credit ratings leaving 14 on negative outlook. In particular France and Austria, which lost their triple AAA status while not particularly surprising, comes as a major blow to efforts to resolve the crisis. The downgrade puts at risk the EUR 180 billion in credit guarantees underpinning the EUR 440 EFSF bailout fund.

Separately the breakdown of talks on Greek debt restructuring and criticism by the Euuropean Central Bank (ECB) on a new draft of a treaty to ensure fiscal discipline added to the malaise, with the ECB noting that proposed revisions amount to a “a substantial watering down”. Such criticism will likely be an obstacle to the ECB stepping up its peripheral debt buying potentially threatening any decline in bond yields. It is difficult to see sentiment improving this week, with risk aversion set to remain elevated as Eurozone leaders attempt to restore confidence. In contrast, US data continues to support evidence of economic recovery, albeit gradual and this week’s releases including industrial production and manufacturing surveys will likely add to this.

The EUR slid further at the end of last week reversing earlier gains, as the bad news mounted in the Eurozone. Ratings downgrades, breakdown of Greek debt talks and ECB criticism over watered down fiscal rules, combined to make a dangerous concoction of negative headlines. The news put an end to the EUR’s short covering rally, leaving the currency vulnerable too further declines this week. Speculative sentiment according to IMM data reached another all time low last week (-155k net positions), suggesting that any good news could lead to a strong bounce as short positions are covered.

However, it is difficult to see where such news will come from and even a small expected bounce in the German January ZEW investor confidence survey this week will do little to detract from the negative news on the policy front. A meeting between Merkel, Monti and Sarkozy will be eyed closely as they prepare for a meeting of European Union (EU) Finance Ministers and markets will be looking for aggressive action to turn confidence around. Debt sales in In the meantime EUR/USD will continue to languish but strong technical support is seen around 1.2588.

Euro sentiment dives to a new low

Equity markets in Europe began the year in positive mood, with gains led by the German DAX index following the release of firmer than expected readings for Eurozone purchasing managers indices (PMI). Chinese data which showed an increase in its PMI also helped to boost sentiment. The Eurozone data however, remained at a weak level, contracting for a fifth month in a row, and still consistent with Eurozone recession.

It seems unlikely that equity gains will be sustained over the rest of this week, with risk aversion set to remain elevated against the background of ongoing Eurozone debt and global growth concerns. Indeed, both French and German leaders in their new-year messages warned about the risks ahead. A meeting between Germany’s Merkel and France’s Sarkozy is scheduled for January 9th ahead of an EU Finance Ministers summit on January 23rd. It is unlikely that there will be any significant policy decisions in Europe before then.

Meanwhile, press reports noting that Germany is pushing for an even bigger write down of Greek debt than previously agreed will only add to risk aversion over the short term. The report in the Greek press highlighted the prospect of a 75% write down of Greek debt a far cry from the 20% proposed some months ago. Eurozone markets continue to be haunted by the prospects of credit downgrades by major ratings agencies at a time when many countries have to issue large amounts of debt to satisfy their funding requirements.

Against this background the EUR is set to remain under pressure, with a notable drop below EUR/JPY 100, its lowest level in over a decade registered. Reflecting the deterioration in sentiment for the currency, EUR speculative position hit an all time low at the end of last year according to the CFTC IMM data. This is unlikely to reverse quickly, with sentiment set to deteriorate further over coming weeks and months as the EUR slides further.

Extreme Uncertainty

The level of uncertainty enveloping global markets has reached an extreme level. Who would have thought that close to 13 years after its introduction at a time when it has become the second largest reserve currency globally (26.7% of global reserves) as well as the second most traded currency in the world, European leaders would be openly talking about allowing countries to exit the EUR? No less an issue for currency markets is the sustainability of the USD’s role as the foremost reserve currency (60.2% of global reserves). The US debt ceiling debacle and the dramatic expansion of the Fed’s balance sheet have led to many official reserve holders to question their use of the USD. Perhaps unsurprisingly the JPY has been the main beneficiary of such concerns especially as global risk aversion has increased but to the Japanese much of this attention is unwanted and unwelcome.

The immediate focus is the travails of the eurozone periphery. Against the background of severe debt tensions and political uncertainties it is perhaps surprising that the EUR has held up reasonably well. However, this resilience is related more to concerns about the long term viability of the USD rather than a positive view of the EUR, as many official investors continue to diversify away from the USD. I question whether the EUR’s resilience can be sustained given that it may be a long while before the situation in the eurozone stabilises. Moreover, given the now not insignificant risk of one or more countries leaving the eurozone the long term viability of the EUR may also come into question. I believe a break up of the eurozone remains unlikely but such speculation will not be quelled until markets are satisfied that a safety net / firewall for the eurozone periphery is safely in place.

In this environment fundamentals count for little and risk counts for all. If anything, market tensions have intensified and worries about the eurozone have increased since last month. Politics remain at the forefront of market turmoil, and arguably this has led to the worsening in the crisis as lack of agreement between eurozone leaders has led to watered down solutions. Recent changes in leadership in Italy and Greece follow on from government changes in Portugal and Ireland while Spain is widely expected to emerge with a new government following elections. Meanwhile Chancellor Merkel has had to tread a fine line given opposition from within her own coalition in Germany while in France President Sarkozy is expected to have a tough time in elections in April next year. The likelihood of persistent political tensions for months ahead suggests that the EUR and risk currencies will suffer for a while longer.

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