Last week’s short-lived euphoria over German and Finnish go-ahead on the ESFS position, and the euro trend it prompted, is typical of the one step forward, two steps back nature of the euro bailout story. Just as risk appetite buoyed indices, German retail sales and US consumer spending data brought swift and sobering risk aversion, forcing the euro’s biggest monthly decline against the yen in more than a year. The shared currency fell like a rock on Friday, finishing near the weekly low at 1.3384.
Progress on ratifying ESFS expansion, though positive, falls short of addressing market doubts about the ability of the fund itself to avert growing risk of contagion. While it removes immediate fears of destructive splits in Merkel’s coalition and eases concerns regarding Finnish collateral demands, it leaves the core question unaddressed. Is the fund large enough to manage Europe’s medium to long-term sovereign debt concerns? Are European and American banks with peripheral exposure capitalised enough to avert insolvency? Going by progress on Greece alone, far from Europe’s biggest debt worry, market sentiment is seen turning increasingly negative.
The barrage of data disappointment from Germany is indicative of a continental slowdown which, at a time of strict austerity in much of the continent, signals another growth contraction around the corner. Yet further slowdown seriously complicates ECB’s upcoming interest rate decision on Oct 6. Already, September inflation (at three per cent) is the biggest annual increase since Oct ’08. Given the ECB’s existential fear of rising prices, a painful reminder of the Weimar Republic’s disastrous hyper-inflation endgame, Trichet’s position comes under further strain as he juggles growth and prices.
That swaps traders are now betting on a 40-basis point reduction in the ECB rate over the next year, as opposed to a 25-basis point increase projected one month ago, is proof of long term unraveling of the euro priced into the market. Sporadic assurances from Merkel and Sarkozy can bid up the currency now and then, but there is little preventing a slide to 1.30 in the foreseeable future. Barrosso’s boast that closer integration will facilitate eurobonds, too, will backfire sooner rather than later, stoking Bundesbank as well as Bundestag discontent.
Continuing inflows into the yen, yet more proof of global economic slowdown, have kept trader anxiety high as the safe-haven impulse risks burning eager longs in case of eventual intervention. Soon, the BoJ will not be able to count on the threat alone to check the uptrend. Yet forceful intervention will require coordinated efforts as in the aftermath of the earthquake, something not too many pundits will count on in the current circumstances.
So, Europe continues to be the bad boy of the world economy, with the US outlook hardly any more certain. The more growth fears factor into the market, the more commodity currencies like loonie, aussie and kiwi will take hits. The environment remains one where risk-on windows are growing thinner by the week.
One step forward, two steps back
