‘I spent the night with Germany’

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Sarkozy’s breakfast meeting admission with his cabinet indicates just how deeply Europe’s sovereign debt crisis has altered perceptions at the Elysee Palace, where years ago Francois Miterrand pushed Gerhard Schroder into compromising Germany’s monetary muscle in favour of the euro to secure France’s go-ahead on German reunification. Ironically, Merkel’s inability to generate unanimity over the euro rescue within her ruling coalition seriously upsets Sarkozy’s re-election bid at home, betraying French fears of the debt debacle snowballing into mainland France, whose bloated debt and over-exposed banks paint a picture disturbingly similar to the periphery.
Yet the more Merkel and Sarkozy push EU leaders into purposeless meetings, the more they feed unrealistic market expectations. And short of concrete assurances of political will in Germany to see the crisis through, the market has priced in a continental slowdown and a further structural weakening of the euro, not helped by the European PMI falling below 50 for the first time in two years. This means that the long happy ride that saw Germany’s mammoth export machine financed by steadily increasing continental debt has finally come to an end.
Expect continued euro weakness as banking system solvency is checked, Italy is downgraded and talk of forced Greek default factors its way into market sentiment. IMF’s recommendation that the ECB consider a rate cut at its next conclave, just as it held steady at the last one, means wide expectations that Bundesbank hawks’ inflation fears will not cloud policy concerns, even if their outright dismissal of eurobonds will keep continental response fractured. Even as the euro closed the week at 1.3497 – after falling to 1.3416 – Friday’s slight uptick banked on ECB promises to address growth risks, not policy convergence on managing peripheral debt. Failure to back words with policy, as usual, will send EURUSD checking 1.3442 support.
Across the atlantic, operation twist and fears of lingering downside growth risks have turned the dollar into the safe haven currency of choice again, prompting net long dollar positions for the first time since July ’10. According to Bloomberg, aggregate bets favouring dollar strength against euro, yen, aussie, kiwi, loonie, swissie, sterling and peso rose to 75,065 contracts in the week ended Sept 20, signaling strong dollar-buy sentiment.
The safe haven dollar inflow will continue so long as the present bout of market risk aversion persists. The swissie continues its steady downslide against the dollar despite Friday’s small correction. The yen, though unlikely to mimic franc-scale depreciation, is jammed in range-bound trading with pundits unwilling to hop on and risk getting their fingers burnt in case of eventual BoJ intervention. Still, with talk of default in Europe and slowdown in the US threatening a safe haven tidal wave in the near future, the BoJ is understandably waiting for the risk-off environment to diminish before committing. Yet some sort of intervention will come. The yen is already at record highs and severely pressuring exports in an already stagnant economy. If traders tap this sentiment, along with the rising dollar, and push the yen below 76.80, it will test the 80 mark.
The week-long loonie drop, coinciding with the dip in curde, is also symptomatic of the direction of the global economy, principally US growth outlook. Its descent to near its lowest levels against the dollar since October means demand for its commodities and lumber is diminishing in America, assuring another contraction in the world’s largest economy. The crystal ball sees Bernanke running from stimulus to stimulus and Sarkozy spending some more nights with Germany before the market finds definitive direction.