Euro drops to fresh two year lows as post-summit bickering further dents European credibility

Tom Tong09/Jul/2012Currency Updates

The rally in risk assets and the euro brought about by the (apparent) progress in last week’s European summit unravelled again in less than a week. The European banking union posited by the Northern core as a prerequisite for aid to Spanish banks was pushed deep into the future by German officials, and European officials went back to bickering over the exact whys and wherefores of the agreement reached (or not).

Worldwide data flow was consistent with a world economy that is growing well below potential and slowing further. Since the dominant austerian ideology in the Western world precludes any significant fiscal stimulus, further liquidity injections by central bankers remain the only realistic help for stagnant economies; clearly, each successive round of monetary easing yields diminishing returns. In this environment of economic gloom and chronic debt crises in Europe, the dollar is performing as we expected, rallying nearly 1% in trade-weighted terms on safe-haven flows.

GBP

As we had forecast, the MPC increased the gilt purchase target on Thursday by 50 billion sterling, to a total of 375 billion. We note that back in early spring when we started pencilling such a move, our’s was a very much out of consensus view. Also, the MPC stated that inflation is more likely than not to fall short of the target over the medium term. Such dovishness had been fully discounted however, and investors remained squarely focused on the European crisis as the driver of FX markets. Sterling went back to the role we predicted for it, acting as a low-beta version of the euro, rising almost 1% against the common currency while dropping by a bit more than that against the greenback.

EUR

European news once again dominated markets last week, in spite of the payroll report in the US. On Thursday, the ECB cut rates (as we, as well as, belatedly, the consensus, expected). However, the statement and the ensuing press conference betrayed an almost lackadaisical lack of urgency on the part of the European central bank in addressing the developing catastrophe, and investors quickly sent the euro sharply lower. Matters were not helped by the apparent back-pedalling of Northern countries on the mildly positive agreements that appeared to have been reached at the previous week’s summit. Germany insisted that no money could be disbursed to the broken Spanish banks until a European banking supervisor is in place, which will not happen for many months. Finland insisted that the Spanish sovereign would remain liable for any help given to Spanish banks, in direct contradiction to the consensus interpretation of last week’s agreements. In short, the Europeans repeated their disastrous pattern.

When catastrophe is imminent, they do the absolute minimum to prevent it; once the immediate danger is past, they backslide and allow things to deteriorate again. Spanish 10-year yields rose sharply, and are again flirting with the 7% level. The euro dropped very sharply to fresh two year-lows, and ended the week below the 1.23 threshold against USD.

USD

The main news of the holiday-shortened week in the US was the June payroll report. It came out weaker than expected, and confirmed a notable slowdown in the US housing market. The economy generated only 80,000 jobs in June, below the level required to keep up with the natural growth in the labour force for the third consecutive month. We must now bow before the evidence and lower our expected growth in the US economy in 2012 from the 2-3% band to 1.5-2.5%. Consumer spending cannot remain above 2% for very long unless workers’ incomes expand, and they show no signs of doing so. We do not, however, alter our positive view of the US dollar. We think that safe haven concerns driven by the European crisis will outweigh the economic slowdown in the US, and maintain our positive view of the greenback.

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Written by Tom Tong

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