Investors re-think their euro positions

There has been a dearth of economic data this week especially out of the US, so investors have instead been focusing on news flow and re-positioning themselves after last week’s major FX moves. This has particularly weighed on EURUSD, which is back below 1.3900 and is down more than one per cent since the start of the week.

While investors were in a scramble to buy the euro last week after ECB President Trichet heavily hinted that rates would rise next month, enthusiasm for the single currency has been tempered by a re-surfacing of investor concern about the sovereign debt crisis. Greece, who was downgraded further by a large ratings agency on Monday, had a disappointing auction of short-term debt on Tuesday. Investors demanded a higher risk premium from Athens even though the country is accessing EU-IMF life support. An auction of Portuguese short-term debt this morning was extremely disappointing and highlighted the shift in sentiment towards Europe’s peripheral nations. The bid-to- cover ratio was lower than it was last year and the interest rate charged by investors to hold 2013 bonds jumped to 5.99 per cent from 4.86 per cent on September 8. This will add to pressure already on the Iberian nation to accept a bailout after its 10-year government bond yield reached a 14-year high of 7.7 per cent earlier in the European session.

Worryingly, investors are also punishing the larger nations of Spain and Italy and the yield on Italy’s 10-year bond yield touched 5 per cent for the first time since the peak of the financial crisis back in 2008. Portugal, Ireland and Greece are manageable, but bailing out Italy and Spain is a real problem.

Investors in the credit markets lost patience with the EU’s dithering over finding a long-term solution to the crisis a long time ago. A currency union will only be viable in the long-term if there is fiscal union and a method of financial transfer between strong and weak nations (think of the system in the US whereby financially troubled states get helped out by the federal government.) Europe needs a “federal financial government” otherwise FX investors may start to lose patience as well. Right now the euro is holding up surprisingly well, and if we see a solution to the crisis (READ: Germany stepping up to the plate) then we could see EURUSD above 1.45 towards 1.50 in the coming months.

For now how Europe will sort out this mess is dominating the headlines. The pound is higher versus the dollar and the euro as we wait for the Bank of England policy decision tomorrow. The markets are expecting the Bank to remain on hold, although GBP 3-month swap rates have moved higher in recent days suggesting markets are pricing in a slight chance of a rate hike. The focus is now on May and then August for the BOE to act and tighten policy. However, a lot rests on the tone of the economic data in the ensuing months; any signs of slowdown could keep the MPC from hiking and may weigh on the pound.

Trade data in the UK for January showed an improvement in the trade deficit at the start of the year as exports surged to a record high and imports slowed. This is encouraging data, but we will have to wait for future months’ readings to see if this is the start of a trend.

Stocks are slightly higher, and the brief rally in oil this morning has run out of steam for now. The dollar is broadly flat and the Swiss franc is lower after annual inflation for February was a very weak 0.5 per cent. But the Swissie remains the safe haven currency of choice so any flare up in Middle East tensions could see a swift reversal in CHF.

Ahead today, the RBNZ meet to set policy and the expectations are that rates will be cut by 25 bp. While some argue that the Bank will cut by 50 bp to boost growth after last month’s earthquake, there is a risk they Bank chooses to avoid rate hikes that affect the whole economy and instead provide liquidity that can flow to the localised area. After all, the re-build of Christchurch will act like a stimulus on the NZ economy later this year and into 2012. SO watch out for NZD volatility later this evening.

Source: FOREX.com

09.03.2011