EU Summit far exceeds
market expectations, fuelling euro rally
Market confidence in the build-up to last week’s EU Summit
was pretty much at rock bottom. Angela Merkel’s continued tough stance on
eurobonds seemed to indicate a wider deadlock between Germany on one side and
struggling eurozone nations such as France, Spain and Italy on the other.
In the early hours of Friday morning, EU chief Herman Van
Rompuy announced several decisions which gave risk appetite and market
sentiment a major boost. Two key questions left by the Spanish bank bailout
deal were answered. First, the bailout funds will be able to directly
recapitalize Spain’s banks, without adding to the debt-to-GDP ratio of Spain as
a whole and forcing its borrowing costs up. Second, the bailout loans will not
be given senior creditor status, easing concerns that private bondholders will
not see their investments completely written off. In addition, pledges were
made that the bailout funds will be able to invest in distressed bonds
directly, again relieving concerns around the Italian and Spanish bond markets.
Clearly the markets were impressed by these decisions and
they certainly buy some more time but they don’t amount to a silver bullet
solution to the debt crisis by any stretch of the imagination. We still lack
any detail on the fundamental issue of longer-term fiscal union and whilst the
bailout resources can be used more flexibly now, though its size remains
inadequate.
ECB and BoE both set to
make moves this week
ECB Chief Economist Peter Praet stated recently that “there
is no doctrine that interest rates cannot fall below 1 percent.” Comments such
as these lead us to believe that the ECB is set to cut its already record-low
1.00% interest rate to 0.75%. There is a significant risk that the ECB will cut
rates to 0.50%, in light of weak eurozone growth data and fading inflationary
risks. Whilst the market is likely to be grateful that the ECB is taking
action, the reduction in the euro’s interest rate differential is likely to be
a negative for the single currency in the longer-term.
We expect the Bank of England to introduce further
quantitative easing on Thursday, in light of the distinctly dovish tone within
last month’s MPC minutes and the four votes in favour of QE that they revealed.
Only one more dovish voter is required for a majority in favour of QE and we
believe this will come on Thursday. The move looks to be fully priced in
though, so sterling has already taken the pain in relation to this move.
Wednesday’s UK services figure will be watched closely on Wednesday, a slowdown
is expected.
End
of week forecast
| GBP / EUR | 1.2550 |
| GBP / USD | 1.54 |
| EUR / USD | 1.2475 |
| GBP / AUD | 1.57 |
The dollar has suffered a significant sell-off amid booming risk
appetite in the aftermath of the EU Summit. We maintain a bullish outlook for
the US dollar moving forward, although the week ahead brings with it
significant risks. Friday’s US non-farm payroll is expected to show a mild
improvement but amid the softness in US growth data of late it would be no
surprise to see the result undershoot expectations.
The euro’s rally has already run out of steam; GBP/EUR is
trading up above €1.2450 and EUR/USD’s has pared back from $1.27 to below
$1.26. We continue to target levels well above €1.25 for sterling. A further
decline in the EUR/USD pair will surely weigh on GBP/USD, which is coming up
against stiff resistance around $1.57.
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