FYI | Dec 21 2011
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
In the absence of Santa, it looks like the ECB could be coming to a town near you this week. After a torrid few weeks it looks like the markets are finally starting to rally. So what is driving it? It could be investors desperate for a rally trying to make it happen after what has been a dismal year especially for European stock markets, but it may also be due to the high expectations for the European Central Bank’s Long-term Refinancing Operations (LTRO) which start in earnest tomorrow for both 3-month and 3-year funds.
This could be fuelling a rally in European bond markets, as I mentioned earlier Spanish 10-year yields are close to 5% and below their 12 month average of 5.45%. Italian bond yields have also declined, although not at such a rapid pace. So it may seem logical to think that banks will load up on funds from the ECB and purchase reams of sovereign debt, however banks are trying to boost capital levels and de-leverage so why would they want to buy sovereign debt from the currency bloc when there seems no end in sight to the debt crisis?
Thus, although stocks and bonds may have rallied today, it may not be sustainable and the Grinch could still steal Christmas. Interestingly, the front-end of the European bond yield curve has not rallied as hard as the long-end of the curve for both Italy and Spain. Some market commentators have speculated that this is unusual because one would assume banks would prefer to buy shorter-dated Treasuries that require lower capital levels than longer-term debt, which throws the assumption that banks will be willing buyers of European debt for the foreseeable future into doubt.
Interestingly, the yield on the EFSF bond has risen by over 10 basis points this week. This suggests that the solution to the Eurozone crisis is a zero sum game: as the weakest states see their borrowing costs fall, the strongest see their yields rise. The EFSF may also come under selling pressure after rating agency Fitch said that if France loses its triple A credit rating then the EFSF would also need to be downgraded. This disputes what EFSF CEO Regling said in an interview at the weekend that the rescue fund could hold onto its triple A if only one country was downgraded.
So while there are many holes in the bulls’ argument right now, there was some good news that has added to the lighter mood in the markets today. Firstly the German IFO beat expectations, which suggests that the largest economy in the currency bloc could be on the road to recovery, next was the Spanish short-term debt auction where investors wanted over EUR 1bn of the 3 and 6-month bills that were on offer. Lastly there was some strong housing data from the US, housing starts jumped by 9.3% in November.
But could this be the last ECB-fuelled swan song for the markets? Perhaps, but it depends on whether or not the rating agencies give Paris the worst Christmas present ever and downgrade France this week. But while that hasn’t happened the euro is happy to remain above 1.31. However, the single currency is still looking vulnerable below 1.3400 in the long term, and needs to break resistance at 1.3130 before 1.3150 and then 1.3200 come back into view. Added to this, the euro is looking weak against the pound. EURGBP has been testing another key support level at 0.8350 today – the lowest level since January. Below here opens the way to 0.8300. The surge lower in EURGBP early last week preceded the fall in EURUSD, will it signal the same this week?
Tomorrow we are waiting for UK minutes from the last BOE meeting. This is unlikely to deviate too much from recent Bank communications. We expect the Bank to sound dovish and reiterate its belief that inflation will fall sharply, thus keeping the chance of more QE firmly on the table. Eurozone consumer confidence is released along with more home sales data from the US and 3Q GDP from New Zealand.
Ones to Watch:
The euro has recovered versus the dollar this week; however its fortunes versus the pound continue to weaken. Since breaking 0.8500 – a key support – this pair has been on a swift downward trajectory. Below 0.8350 opens the way to 0.8280 – the lowest levels of the year and the 100% retracement of the 0.9080 high reached in early May. Certainly in the short-term the outlook for EURGBP remains weak on a technical basis, but what about a long term basis? The low reached in mid-2010 – at the peak of the Greek crisis – was 0.8060, so there could be further downside from here. However, on a daily basis this pair is starting to move into oversold territory so we could see some pullbacks as we near 0.8300. Added to this, EURUSD may benefit from the fact that people are so short euro already, which could cap losses in EURGBP.
However, from a fundamental perspective, if France is downgraded will the UK follow? If that happens then EURGBP could reverse course fairly sharpish.
Overall, there may be short-term weakness, but as we get to these stretched levels and thin markets watch out for some volatility in EURGBP.
Short-term chart (30mins) EURGBP – a clear downward trajectory
EURGBP longer –term chart: the MACD looks like it is moving into oversold territory
The views expressed are the author's, not FNArena's (see our disclaimer).
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