The past week has seen a shift in the outlook for the euro. Not that long ago people thought that if the EU summit delivered more than the market expected and took steps to stabilise Italy and Spain’s financial predicaments then the euro could rally following a reduction in credit risk in the region. However, that did not happen. Instead, in the week after the end of the EU summit the euro is 2.5% lower against the dollar and 2% lower on a trade-weighted basis. Added to that Spanish and Italian bond yields have risen sharply since the start of the week and at the time of writing Spanish yields were flirting with the 7% level that is considered bailout territory.
So why the sell-off in the single currency? We don’t necessarily think it is because the markets were disappointed by the EU summit. In fact, the summit delivered more than the market generally expected included steps towards banking union, more flexibility for the ESM/ EFSF rescue funds and also the EU may scrap seniority clauses in its bailout loans to Spain’s banks. Although we need more detail, especially on the extension of the ESM/ EFSF rescue funds, this delivered more structural change (although no more money) than we have seen at any of the 18 other emergency EU summits.
Instead we argue that the sell-off in euro-based markets was down to two factors: 1, the ECB not offering a stronger tonic than rate cuts at its meeting on Thursday and 2, some bickering among EU politicians, especially those in the Northern Bloc, who don’t like the idea of extending the powers of the EFSF/ ESM and are also against scrapping the seniority clause in Spanish bailout loans.
The ECB met on Thursday and cut interest rates by 25 basis points to 0.75% (a euro-era record low). It also cut the interest rate that it pays to banks that leave money with the ECB to 0% in an effort to boost lending in the wider economy. However, this may not work. Europe’s banks have been parking large amounts of cash with the ECB and by cutting the interest rate they earn to zero it actually erodes their profitability. Added to that, in an era of austerity there is no guarantee that the banks will either want to lend, especially to riskier customers, or that there will be demand for loans when the growth outlook is so bleak and unemployment in the region reached a euro-era record of 11.1% in May.
The ECB failed to announce, or even hint, that it would adopt more unorthodox measures to try and stem this crisis. There was no mention of LTRO 3, no sign of QE or a resumption of the SMP bond-buying programme. Essentially the markets want the ECB to act as a bridge from where we are today (a dysfunctional union with a major credit imbalance problem) to where we want to be in the future – the land of fiscal union. That will take time and the politicians need to hash out the details, which could take months, therefore, the markets had expected some more radical action from the ECB last week. We do think that eventually the ECB will re-start its SMP programme if Eurozone bond yields move even higher, however, because it failed to do so on Thursday this added to the upward pressure on Spanish and Italian bond yields at the end of last week.
We also mentioned that bickering by politicians could hurt sentiment. The German finance minister was speaking on Friday and said there can be no aid to Eurozone members without conditionality, which threw into doubt the summit “breakthrough” that the EFSF/ESM rescue funds, could re-capitalise banks or buy sovereign debt without having to impose strict austerity programmes. Thus, there will be no money for nothing from Europe’s strongest economies.
So how does this impact the euro? The euro tends to fall when credit risk rises, hence EURUSD has declined along with the rise in Spanish and Italian bond yields. Added to that the ECB didn’t take any measures to reduce credit risk in the currency bloc, at least not in the short-term, and instead made some drastic cuts to interest rates. This eroded the euro’s yield differential, and since yield is a key driver of FX, we believe these rate cuts signal a lower euro for the short-to-medium term.
The 2-year Eonia swap rate (which is used to price the value of the euro in the swaps market) fell sharply on the news, and that seems to be one of the key drivers of weakness in the single currency. The rate differential between Germany (as Euro-area benchmark) and UK Gilt yields has narrowed sharply since yesterday as the ECB and credit risk in the periphery drive safe haven flows into Bunds. This is weighing on EURGBP. 0.7980 had been a major support level; since this has been broken we are looking at fresh multi-year lows for this pair potentially towards 0.7750 in the short-term.
The rate differential between Germany and the US is also euro negative, and since we expect the Federal Reserve to remain on hold when it meets in late July/ early August we believe EURUSD losses could be extended. 1.2280 is the next major support level, which is the low from early June. Below here opens the way to 1.20 – the April 2010 lows. Short euro positions are already stretched, so the decline may not be even, thus, we could see some pullbacks along the way, especially if the Fed is particularly dovish in the coming weeks. 1.2450 is key resistance ahead of 1.2620.
The global central bank liquidity fest
Central banks stole the limelight last week after the ECB, BOE and the PBOC in China all loosened monetary policy within 45 minutes of each other. We doubt this was coordinated action, and the ECB’s Draghi said it was not at his press conference on Thursday; however it highlighted global officials’ fears of a global economic slowdown and concern that the economic and financial situation could get worse in the coming months.
While the ECB and BOE moves were well flagged to the market, China took the market by surprise. It was the second rate cut in a month, the June cut had been the first cut in four years. This suggests the Chinese authorities are worried. We get a raft of June data released by the Chinese authorities next week including Q2 GDP, retail sales and trade data. Since the authorities tend to pre-empt bad news, the risks are tipped to the downside that growth in the Asian powerhouse may dip below the 7.9% annual rate expected by the market in Q2. The PBOC said in a statement that it would still watch the housing market closely, to prevent any bubbles forming. Thus the Chinese government is treading a fine line between loosening monetary policy to boost growth, without letting it get out of control and fuel unsustainable real estate bubbles. Due to this we may not see the same market rally as we did in ‘09 when the Chinese authorities embarked on the world’s largest stimulus plan. We believe they may only boost public spending in the event of a sharp deterioration in the economic data or an escalation in problems in the Eurozone.
Thus, although we believe the outlook for the euro is weak, the outlook for other asset classes and for commodities is also cloudy. The Aussie dollar reacted well to the Chinese rate cut on Thursday, but it could not keep hold of its gains on Friday. Post the US payrolls data, AUDUSD fell below key support at 1.0250 – a cluster of daily moving averages, and now threatens to re-test the 1.0200 recent lows. The failure for this cross to sustain gains above 1.03 is worrying, and the weak payrolls number combined with concerns about the Chinese economy could see the Aussie re-test the 1.0070 low and top of the Ichimoku cloud. Below here is the end of the technical uptrend in the Aussie.
Will the Fed join the party?
The June payrolls data was neither too hot nor too cold, which for Goldilocks may have been the perfect temperature, but after some lacklustre economic data of late the US needed some piping hot labour market data to be able to sustain a rally in risk. Stocks were lower after the 80k reading in payrolls and the dollar and other safe havens were higher. Treasury yields were sharply lower, which dragged USDJPY back towards 79.50. With data this boring then it’s hard to see USDJPY making too much progress towards 80.50 – the top of the weekly Ichimoku cloud and a major resistance level.
We had been looking for a much stronger payrolls number (175k) because of 1, a stronger ADP report for last month, 2, strong employment sub-indices in the ISM manufacturing and non-manufacturing surveys for June and 3, an improvement in corporate sector layoffs. Thus the actual figure is much worse than other labour market indicators suggest.
However, we could puff until we are blue in the face that the NFPs may be underestimating the strength of the US labour market; however this is what the street looks at and where it decides if the Fed is likely to take more policy action at its meeting at the end of this month. So will the Fed join the liquidity party? We think not. The bar to more QE is extremely high and this data is not weak enough to spur Fed action. Unless we see a sharp deterioration in the sovereign debt crisis in Europe we don’t expect the Fed to act, although three weeks is a long time in financial markets. We can see the dollar strengthening next week and further declines in stocks as the markets get used to the idea that monetary policy can’t solve the problem of too much global debt and not enough growth.
A lot resting on the Bank of Japan’s shoulders
The Bank of Japan meets on Friday, it is not expected to adjust its interest rate, which is already only 0.1%; however the Bank may choose to boost stimulus after the action taken by the ECB, BOE and PBOC. It may choose to further extend the duration of JGB’s it buys and it could also make more targeted bond purchases. Also, if we see a stronger yen then there is a chance the BOJ may target the FX rate; however periods of FX intervention by the Japanese authorities tend to only have a short-lived impact on the yen. Thus, unless the BOJ boosts stimulus in a big way at Friday’s meeting we don’t think it will change the direction of USDJPY, which may weaken further if US data continues to surprise on the downside.