Euro plummets as Italian yields reach bailout levels
28/Nov/2011 • Currency Updates•
Reality finally cought up with the common currency last week. Risk assets worlwide sold off as the crisis in Euroepan sovereigns worsened significantly. Italian yields surged clear past the point that forced Portugal, Greece and Ireland to seek a bailout in the past. Further news emerged that the peripehral crisis is spreading to the core. News outside Europe was not helpful, either, with a large 3 point drop in Chinese manufacturing confidence and the collapse of the supercommittee debt reduction talks in the US. However, it is clear that investors worlwide are focused squarely in the worsening disaster out of Europe. There are no signs that German or ECB policymakers are any closer to accepting, or even understanding, the reality of the situation, and we see no reasons to be optimistic at this stage. The Euro started to close the large gap between its still lofty valuation and the disastrous European situation, and dropped over 2% against the dollar.
We were somewhat surprised by last weeks’ relaese of the November MPC minutes. There was unanimous agreement to keep both rates and the level of asset purchases unchanged. Given the negative tone of the latest Inflation Report, we would have expected at least some members to vote for further purchases of Gilts. However, it must be remembered that the Minutes are three-weeks old, and much has happened since then. We expect that the disastrous events out of Europe will nudge a few members towards a further increase in the purchase target as early as next meeting, and a majority will vote for them early in 2012. Meanwhile, demand figures for 3Q GDP were released, confirming our view of fast-slowing private demand and the distinct possibility of an outright contraction in 4Q. It is a significant development that the surprising hawkishness of the Bank of England did nothing to support Sterling, which fell in against the dollar in lockstep with the Euro.
The not-so-slow-motion trainwreck in the Eurozone sped up a bit last week. An Italian bond auction went badly, forcing the sovereign to pay an eye-popping 8% for 2-year bonds. This is a completely unsustainable level, and well past the point where Greece, Ireland and Portugal were forced to ask for a bailout. Ominously, stress extended to core European sovereigns, and a sloppy auction of German debt suggested that investors are fleeing an increasingly disfunctional Eurozone. We fail to see how the EFSF bailout facility will be able to sell debt in the large amounts needed to bailout Italy in these circumstances. Only the ECB has the necessary firepower to do so, but its officials show no sign that they are about to give up their struggle against financial and economic reality. Meanwhile, macroeconomic data continues to deteriorate, as the recession spreads from the periphery to the core and confidence collapses. Unemployment rose again to 10.3% in October, and September manufacturing orders plunged by a dramatic 6.4%. The news that the conservative PP party had obtained a clear majority in the Spanish elections had essentially no impact in markets, indicating that investors do not believe internal policies in the distressed sovereigns will make much difference in the Eurocrisis. The common currency, meanwhile, began to close the massive gap that has opened up between its relatively high valuation and the levels of stress in European bond markets, dropping over 2% against the dollar.
Macroeconomic newsflow out of the US turned more mixed last week. 3Q GDP was revised down to 2.0% from 2.5%, though this was entirely due to inventories, leaving domestic demand growth unrevised at 3.6%. More disappointing were the news on durable goods orders, and October consumer spending. Whilst there appears to be sufficient momentum to keep growth positive thorough the end of 2011, 2012 is shaping up to be a very difficult year. A combination of fiscal drag, dropping consumer cinomes, weak asset prices and the unpredictable fallout from the European disaster makes us think that a double dip recession for next year is quite possible unless policymakers take aggressive steps both in the US and Europe. The current backdrop, however, is positive for the dollar, which we expect to be supported by its safe haven status, its atractive valuation, and the absence of explciit intervention against its appreciation.