Euro rallies sharply after ECB hints at further bond purchases

Tom Tong30/Jul/2012Currency Updates

FX markets continue to focus primarily on the official response (or lack thereof) to the European sovereign crisis. This week, the ECB did yet another about face, as Draghi pledged to do “whatever it takes” to preserve the euro, and hinted strongly at further purchases of distressed sovereign bonds. Currency and bond markets were surprised by such a reversal in policy intentions. Peripheral yields dropped sharply, with the Spanish 10-year yield ending the week a full point below its recent record levels of 7.7%. The common currency rallied sharply against other majors to end the week up 1.6% against the USD and 0.8% against sterling. Other asset markets were much more subdued.

Equities outside Europe were generally flat to lower for the week, and commodities dropped 2% as agriculture and energy gave back some of their recent gains. All eyes turn now to critical events next week. The Fed, the ECB, and the Bank of England all meet, and the week ends with the release of the all-important payroll report in the US.

GBP

The Office of National Statistics delivered a nasty jolt to the markets on Wednesday. UK GDP shrank a much-worse-than-expected 0.7% QoQ in the second quarter, or close to 3% in annualized terms. The main culprit was a dramatic contraction in the construction sector. The Jubilee holiday accounted for some of the drop, but even so the weakness of the UK economy is very worrisome. We now think that growth is likely to turn out barely positive next quarter, for the first time in a year, due to the Olympics, the absence of the Jubilee holiday, and the low starting point for output. Sterling did not react well to these news, dropping by well over 0.5% vs. the euro in the moments following publication of the GDP data. For the week, sterling reverted to our predicted long term trend, where it behaves as a low-beta version of the euro; rising against the Greenback and falling back along most major currencies against the resurgent euro.

EUR

Exploding peripheral yields ended up forcing yet another dramatic policy reversal from the ECB. Draghi declared that “the ECB is ready to do whatever it takes to preserve the euro” and proceeded to hint that he stands ready to restart direct purchases of peripheral bonds. In parallel, ECB council member Nowotny said that there were arguments in favour of granting the European facility a banking access and thus access to ECB liquidity, which would dramatically increase its firepower. Markets reacted euphorically sending the euro sharply higher and peripheral yields lower. European officials continue their policy of waiting until disaster is imminent, and then doing the bare minimum to prevent it or at least delay it. This is having predictably disastrous effects on consumer and business confidence in the eurozone. Consumer confidence fell sharply in June, whereas business PMIs were steady at a contractionary level of 46.2; German confidence indicators continue to deteriorate, while those in the periphery fail to improve. Overall, we see no reason to change our bearish view of the euro, and expect the downtrend to continue once the short position overhang is cleared out.

USD

Second quarter GDP figures provided further confirmation of the slowdown in growth in the US. GDP grew just 1.5%, about in line with consensus. Housing and non-residential investment grew strongly, at 7.2%, while net exports and business investment in structures were a drag. Overall, this datapoint does little to change our view that US growth is likely to come in within the 1.5-2.5% range over the next few quarters. However, we are paying very close attention to next Friday’s critical payroll figures for July. Any large surprise in either direction would probably force us to reconsider our forecast in the appropriate direction. No change for now in our views for the US dollar, which we expect to continue to benefit from uncertainty and safe haven flows over the medium term.

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Written by Tom Tong

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