London Session: Capricious Markets a Reaction to Europe’s Unsolved Problems

It has been a wild ride in FX this morning. The foreign exchange markets have reversed course and the euro, Aussie and pound are making fresh highs of the day while the dollar and the yen have started to come under pressure. Due to the close correlation between risky FX and stocks and commodities, the move higher in the single currency has been followed by a moderation in losses on European bourses.

So what is driving risk? Anyone who read the papers this morning would think that the situation in Europe had deteriorated in the last 24 hours and this should be euro negative. Indeed, reports suggest that a rift has developed between France and Germany on how to equip the EFSF rescue fund to stem the sovereign crisis that now threatens to engulf Italy and maybe even France.

The problem centres on how to increase the size of the EFSF (Germany doesn’t want it to be leveraged or become a “bank” that could borrow from the ECB, while the French do). Likewise, France doesn’t want a swift recapitalisation of its banks because it can’t afford to inject more money to its lenders if they don’t attract funds from the private sector, while Germany does. The ECB doesn’t agree with the plan to increase private sector haircuts on Greek debt and the IMF doesn’t think that Greece’s long term fiscal consolidation plans are stable, unlike the EU and ECB, and may not release the next tranche of bailout funds due by the middle of next month.

So there is no entente cordiale in Europe right now. However, the markets are not willing to give up hope. Although dreams of a final solution being found this weekend are being put on the back burner, the market still seems confident that there will be some progress at the weekend and sentiment is placated by the fact Europe’s high command seem to have grasped the severity of the situation.

Thus, the markets seem to be reacting more to the “positive” news out of Europe than the negative. Rumours that a draft package of reforms had been collated helped the upswing in risky FX, and an EU spokesperson said that the EU needs to leverage the EFSF rescue fund to increase its firepower. This is considered a step in the right direction, even if a leveraged EFSF brings up its own problems

The market isn‘t worrying about the reduced growth forecast from Germany for 2012. The forecast was reduced to a mere 1%, although the economy minister ruled out a German recession. Growth for 2011 is expected to be 2.9%. This is something that the markets should be focusing on as France is now coming under pressure and its bond yields are rising sharply, which means that Germany may be on the hook for a very large chunk of bailout funds. Let’s hope the German taxpayer has broad shoulders.

I can’t help but think this rally is on a very flimsy basis. Arguments abound that the current rally is based on short covering and indeed, according to CFTC data short speculative positions in euro remain at stretched levels. However, we continue to think that real money – or longer term investors – is on the side-lines until there is more clarity on whether a solution to the sovereign debt crisis will emerge.

Added to that, it’s doubtful that the real problems that are hurting the Eurozone will be addressed. The morning papers said that the European Banking Authority had said the currency bloc’s banks need an extra EUR70-90 billion in capital, which is far less than the EUR200 billion the IMF concluded. So yet again we may be in a situation where Europe buries its head in the sand and doesn’t own up to the extent of the crisis or the way that it has ravaged the region’s banking sector, which will ultimately weigh on growth. Japan failed to deal with its banks and this led to a lost decade of no growth – Europe is perilously close to making the same mistake.

Debt auctions in Spain and France went ahead today although stresses in the credit markets have started to rear once more. The Franco/ German 10-year bond spread rose to a fresh record this morning of nearly 120 basis points, and Italian yields were close to 6% before the ECB was rumoured to be intervening in the markets, which caused yields to fall 7 basis points. France had to pay significantly more for its debt at the auction, while Spanish yields actually moderated compared to some auctions in July. However, crucially for the EU authorities, there is still demand in the primary markets for core European debt, even if it is down to the fact investors can quickly sell it in the secondary market to the ECB.

Expect this saga to continue today with the Greek austerity vote scheduled for later. This is expected to go off without a hitch, but a national strike has turned nasty, which could dent investor sentiment.

Elsewhere, UK retail sales had a good month in September, with sales excluding gas expanding by 0.7% on the month. However, the three month average remains subdued and sales are unlikely to be much of a boost for growth for the rest of this year. The pound remains driven by risk sentiment, although EUR/GBP is stuck in a range as both GBP/USD and EUR/USD continue to trade well. But the euro has managed to appreciate versus the pound today, which shows the strength of risk sentiment.

This price action is fascinating to watch but frustrating to trade. However, we continue to believe we are stuck in a range and any bouts of optimism will be capped. Since the single currency seems to be leading other asset classes, when EUR/USD approaches 1.3850-70 we think investors may start to get cold feet and start to book profits on their risky positions.