Euro, financial assets rally as European summit underpromises and overdelivers
02/Jul/2012 • Currency Updates•
Last week financial newsflow was dominated by the European summit taking place Thursday and Friday. The headlines on Friday morning were considerably more positive than expected, as Germany partially caved in to some of the Spanish and Italian demands. Spanish banks will be bailed out directly by the European bailout funds, without burdening the sovereign with additional debt. These funds will be able to purchase sovereign debt without Italy and Spain having to commit to additional austerity. These are significant, albeit nowhere near sufficient, steps in the right direction. Given how low expectations are whenever European officials are involved, it is no surprise that equities and commodities worldwide rallied and the dollar sold off sharply on Friday. While the measures agreed will ease the liquidity plight faced by Spain and Italy, there are deeper solvency issues. The economies of those two countries are in a steep decline, and we need to see far more concrete steps away from disastrous austerity policies before we change our negative view on the euro.
Market moving data were scarce in the UK last week. The main release was the confirmation that GDP had indeed shrunk at a 1.2% saar rate in the first quarter. This should provide further ammunition for the dovish members of the MPC. We expect the Gilt purchase target to be increased by 50 billion GBP next week, while we think there will be no change in the interest rate level; it is too close to zero to make a difference. In the absence of significant domestic macroeconomic or policy news, sterling traded more or less in line with the euro all last week, ending the week up over 1% against the dollar but flat against the common currency.
As we note above, trading in the common currency was dominated by the European summit that took place later in the week. It must be admitted that, whether they intended to or not, European officials for once did a masterful job of guiding expectations lower prior to the conclave so that markets would be, for once, pleasantly surprised by the outcome. The burden of bailing out Spanish banks will not fall on the beleaguered Spanish sovereign, and both Spain and Italy will be able to ask for direct purchases of their bonds in the markets by the bailout facilities without having to commit to further austerity measures.
These are welcome steps in the right direction, but we still need to see a much more decisive turn away form austerity in order to halt the freefall of the European economies. There were not many critical releases last week that would shed light on the state of demand, but what little there was added to our worries. German unemployment increased in June for the third straight month. Employment in Germany has been one of the very few bright spots in the area’s economy, and it looks like it may be beginning to fade as well.
The common currency reacted euphorically to the summit news, rising by close to 2% in a single day. We think the rally may have some short-term legs, as the short position against the euro is still extremeley high. However, we expect it to peter out soon, as the dire state of the economy replaces relatively positive policy headlines in driving the newsflow.
The mostly second-tier reports out of the US this week were consistent with the picture we have been painting of the US economy: a sharp slowdown in manufacturing being partly compensated by an upturn in the housing sector, while consumer growth posts figures of around 2% in real terms. All eyes now turn to the critical employment report next Friday. We are paying this number even more attention than usual: whether or not consumer demand continues to support the recovery hinges on minimally sustained employment and wage growth. After a sharp weakening of the dollar on the heels of the European summit, we expect FX trading to focus again on macroeconomic trends starting late next week.