Euro moves lower again as investors await news from next weekend summit
25/Jun/2012 • Currency Updates•
Currencies and risk assets in general continued to move in the pattern of the past couple of weeks. Sharp moves in either direction without a clear trend in most asset classes, while the risk-on /risk off trading regime weakens somewhat and referent markets move in different ways. The dollar strengthened, recouping its losses from the previous weeks. Equities were flat to slightly down in most markets, while commodities continued to under perform sharply. The economic backdrop worldwide is clearly deteriorating. Central banks are following the script we laid out some time ago, getting ready to throw more monetary easing into the battle. The Fed, Bank of England, Bank of Japan, Bank of China, and the central banks of most other key emerging markets have already taken a clear turn towards dovishness, either through rate cuts (wherever rates are not already at zero) or through further rounds of unconventional measures. We expect the ECB to follow suit soon, though we will not underestimate the stubbornness with which European authorities manage to ignore reality.
While additional easing certainly will not hurt, we believe that it will have a low and diminishing impact. The problem for the worldwide economy is a chronic shortage of aggregate demand, particularly in the advanced economies, and the resulting lack of business confidence and investment. The problem can only be solved through determined easing in fiscal policy, particularly in Europe. Until we see signs that policy makers understand this, we are cautious about risk assets in general and continue to favour the US dollar as the best of a bad bunch among currencies.
The main news of the week was the publication of the minutes from the Bank of England policy-setting meeting earlier in the months. These validated our view that the MPC is increasingly worried about the weakening data domestically and abroad, and it is getting ready to announce a further expansion of its quantitative easing policy as early as next month. This month’s decision to keep policy unchanged was a very close 5 to 4, and the dissenters include Mervyn King, the head of the committee. Last week’s inflation report (headline CPI slowed down again, from 3.0% to 2.8% yoy) will have if anything strengthened the hand of the doves. Our view of a further expansion of the balance sheet by 50 billion GBP has now become close to the market consensus. Once further easing from the ECB is also priced in, we expect to see a continuation of the trend towards a higher Sterling against the Euro, but lower against the dollar.
News that pro-bailout parties would be able to form a Government in Greece proved constructive for sovereign spreads in Spain and Italy, but not so much for the common currency, which dropped back to near its recent lows against the dollar. Meanwhile, Germany continues to shoot down all the timid measures requested by the beleaguered periphery. It refuses to support direct recapitalization of Spanish banks (in order to avoid overburdening the sovereign with debt); it demands that all existing and future sovereign debt be made subordinate to bailout debt; and it will not go along with any proposal to issue joint European debt. In any case, we think that all these are liquidity-enhancing measures, which would not solve the underlying solvency issue: in a context of 25% (and rising) unemployment and a depressed European backdrop, Spain will not be able to service its debts. Fiscal stimulus (by whatever name) remains the only viable tool that could bring European demand to the level that may enable Spain to grow its way out of the mess it is in. The announcement of a timid growth initiative that contains almost no new spending or tax cuts does not indicate that northern European opposition to fiscal policy will be dropped any time soon. Therefore, we maintain our bearish view on the Euro; we also expect the ECB to announce further liquidity enhancing measures and/or easing of policy at its July meeting.
The US economy continues to display signs of weakness. The mostly second-tier data released last week are consistent with a manufacturing and investment slow down. Weekly jobless claims edged up, and industrial sentiment indicators like the Philadelphia index surprised to the downside. However, This disappointing news is being balanced out to some degree by a more positive news on the consumption front. Housing data, on balance, continue to paint a positive picture of a sector that hit bottom some time ago and is now providing moderate support to the expansion. Also, sharply lower oil prices will replace some of the uplift that stagnant wages and lackluster job creation are failing to provide. For now, we maintain our view of moderate economic growth of about 2%, but are waiting for the June employment report for confirmation.