Euro slide halted by ECB's bond market intervention

Tom Tong06/Dec/2010Currency Updates

Forex markets were once again focused last week on the peripheral crisis in Europe. Last weekend announcement that Ireland would cave in, continue to guarantee all Irish senior bank obligations and tap a rescue package failed to assuage market fears. Only on Wednesday, when Trichet hinted that the ECB would significantly expand its purchases of peripheral debt, was the slide in the euro and peripheral bonds halted.

An interesting development is that non-European asset markets appear to be decoupling from European woes. Commodities and US stocks rallied even as the euro dropped and spreads blew out earlier in the week and continued to rise after the turnaround in the EUR on Wednesday. Crude oil and the S&P500 index both closed the week at fresh post-crisis records.

GBP

Last week did little to clarify the medium-term prospects of the British economy. The PMI sentiment for manufacturing rose quite strongly, while those for services and construction were largely unchanged at levels still indicating that the recovery is proceeding. However, very little of the upcoming fiscal retrenchment has been felt so far. Generally soft housing prices may be providing us with a leading indicator of the impact of the austerity measures in business and consumer confidence. In any case, Europe is providing further proof that the combination of tight fiscal policies with loose monetary settings are generally bearish for currencies, and therefore maintain our negative view of sterling against most major currencies except the euro.

EUR

Another frantic week of volatile trading and behind-the-scenes manoeuvring in the common currency. The announcement of the Irish bailout package did nothing to calm nerves; indeed, the euro dropped sharply earlier in the week, breaching the psychologically 1.30 level vs. the dollar. Peripheral spreads broke to record highs. Ominously, Belgian sovereign bonds sold off sharply, and pundits struggled to add a B to the PIIGS acronym.

All of this changed drastically on Wednesday, as Trichet announced an expansion of ECB purchases of peripheral bonds, even though it already holds nearly 20% of all the outstanding debt of Portugal, Greece and Ireland. This had an electric effect on the markets, as speculators covered their bets against peripheral bonds and the euro rallied sharply over the next two days to end the week almost unchanged against the dollar.

Our bearish view of the euro over the last few months has certainly been vindicated. However, given the more aggressive stance of the ECB, the notable clearing of long-euro speculative positions and the lack of any immediate prospective catalysts for a further sell off, we would adopt a short-term neutral stance on the common currency. Longer term, it is quickly becoming conventional wisdom that the problem with peripheral countries is not one of liquidity but rather solvency. These bailout packages at punitive interest rates and coupled with draconian austerity packages do nothing to address these fundamental long-term unbalances, and we cannot avoid a general negative outlook towards the euro.

USD

The steady drip feed of positive second-tier economic reports of the last few weeks is not fully translating yet into the major macroeconomic figures that US authorities focus on. Last week brought negative news on housing (the Case-Shiller Home Price index dropped more than expected, indicating a potential new leg down in US house prices) and, critically, the labour market report was a significant disappointment. The economy is not yet creating jobs fast enough to keep up with the growth of the labour force, and the unemployment rate drifted upwards to 9.8%.

Although USD trading action was driven earlier in the week by the gyrations of the euro and the peripheral crisis there, weaker domestic news finally affected the greenback on Friday. It lost some ground against major currencies other than the euro, and finished the week down 1.2% in trade-weighted terms.

Other G10

While the correlation between the Japanese currency and US rates appears to have loosened up somewhat, the JPY is now reacting to US macroeconomic news. After spending most of the week drifting up and down in response to the euro crisis, it rose sharply in reaction to the weak US labour report on Friday. This development bears watching, and for now we maintain a short-term neutral but long-term bearish view of the Japanese currency.

A very strong week for all three dollar Bloc currencies. They all managed to benefit from both the EUR woes earlier in the week and the dismal job report in the US on Friday. This very strong performance came despite some weaker-than-expected numbers in Australia (3Q GDP) and Canada (November employment data). None of this mattered to traders looking for the new safe havens amidst the European crisis and the weak US recovery, and AUD, NZD and CAD were all up anywhere from 2 to 3% for the week against the USD.

The main news out of Scandinavia last week was Swedish third-quarter GDP, which came out considerably stronger than expected. Both Scandinavian economies are outperforming significantly both the Eurozone and the US. Their currencies, NOK and SEK, rallied in tandem throughout the week to end up roughly 1.7% against the euro, while the cross rate was not significantly changed.

Next week is a busy one for Central Bank meetings. We have the Bank of Canada, the RBNZ, the Bank of England and the RBA.

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Written by Tom Tong

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