Euro slide continues in spite of risk asset rally
16/Jan/2012 • Currency Updates•
We have been highlighting for some time the key shift in financial market correlation that has taken place over the past few weeks: the inability of the Euro to rally even as equities, commodities, and even peripheral bonds hold their ground. This new regime was fully operative last week. Risk assets managed to eke out some gains, shrugging off the generally bad tone of macroeconomic news worldwide. However, the common currency was shaken on Friday by the news that S&P had downgraded a new set of sovereigns heretofore considered part of core Europe, including France. Soon after, the surreal talks between Greece and private bondholders about “voluntary” debt reduction collapsed, and the Euro headed for yet another weekly loss. Overall, we are impressed by the resilience of equities worldwide given the stream of terrible news coming out of Europe, and also by the inability of the Euro to even hold its ground in spite of the still massive short position traders have against it, and the negative consensus that has developed around the common currency. It looks as if the Euro has become the funding currency of choice for all sorts of speculative trades – and we can well understand why.
Sterling has the dubious honour of being the only major currency against which the Euro has managed to hold its value so far in 2012. This has largely to do with the timing of the coming European contraction. This will probably happen slightly sooner in the UK than in the Eurozone, although we expect it to be both shallower and shorter in the UK. November industrial production contracted a sharp 0.7%, and this brought further confirmation that the dilemma between negative output news and more neutral sentiment data is likely to be resolved in favour of the former. While the Bank of England chose to leave both rates and its balance sheet unchanged, we think that an increase in the size of Gilt purchases is more likely than not to be increased sometime during the first quarter. As for Sterling, we think it has further to drop against the dollar, but expect it to rally against the Euro.
Eurozone authorities appear to be determined to continue their struggle against financial and economic reality. On Thursday, the ECB made it clear that further cuts are not in the immediate agenda, in spite of the economic meltdown that is now spreading from the periphery into the core. Fortunately, Draghi does keep enough of a tether with the real world to ensure that Spanish and Italian debt auctions come off without a hitch, albeit at levels that are still far higher than is sustainable. Another very surreal European play appears to have come to an end in Greece. Unsurpisingly, private bondholders appear to be unwilling to give up half or more of their money while the ECB and the IMF get paid in full on their substantial Greek debt holdings; debt talks, such as they were, collapsed on Friday and a hard default appears to be the more likely resolution. A full two years have now been wasted by European dithering and can kicking. In the meantime, the Greek economy has collapsed; there’s risk of serious unrest or worse in that country; the debt crisis has spread to almost every European country save Germany; and the continent is probably back in recession, having experienced almost no recovery from the Lehman collapse. Merkel’s response over the weekend was, as may be expected, to ask for more of the same failed policies, except faster. We see no reason to revise our bearish view of the common currency until those who have the power to change the disastrous course Europe is on (i.e., the German financial and econmic establishment) give some sign of doing so.
Macroeconmic data out of the US last week were disappointing, and a timely reminder not to get too carried away with optimism in regard to that country’s economic recovery. Retail sales in December increased only slightly from the previous month, and the trade balance showed some impact from the slowing worldwide economy; trade will probably subtract about 0.3% from fourth-quarter growth, mostly due to lower exports. We still think that the US economy will weather the European disaster better than most, but does not mean there will not be an impact. Nevertheless, we are bullish on the dollar as one of the least undesirable currencies out there. The markets continued to be kind to our view last week, as the trade-weighted dollar increased a bit under 0.5% from the previous week’s close.