LONDON SESSION: Politics and Fundamentals out the Window for the Euro

Risk is staging a stunning rally today; EURUSD has had a large move higher and has attempted to get above 1.3800. Above here opens the way back to 1.4000. After the sell-off in the euro in recent weeks some people called time on the single currency, however, the phoenix-like the euro continues to rise out of the ashes of the sovereign debt crisis.

There are few fundamental drivers for the euro today. Firstly, Slovakia failed to pass a vote on an extension of the EFSF rescue fund that has to be ratified by all 17 Eurozone members before it can be put in place. Although the Slovaks are expected to fudge the issue, hold another vote and give the EU high command the “yes” vote they are after by the end of this week, it doesn’t solve the issue. The Slovak vote was for changes agreed at the July EU summit that are now deemed woefully inadequate. Although there have been noises from various EU officials that the 23rd October EU summit will make real progress on solving the crisis, the political dynamics of the Eurozone means that progress will be glacial even if they do come to conclusions in the coming weeks about bank recapitalisations and an increase in the haircuts on private sector holdings of Greek debt.

On a fundamental basis there is not much concrete evidence to prop up the euro, so what is driving risk? Just as the markets fled risky assets and dived into the liquidity of the dollar, we are seeing an equally sharp exit from liquid assets. The dollar is down more than 1% so far today, while AUDUSD is up 2.5%. So are investors worried they will miss out on a major rally if Europe solves its problems? Or is it optimism that the global central banks will provide plentiful liquidity, including a round of QE3 from the Federal Reserve in the US, which is dollar negative and positive for risky assets like stocks and commodities? The other alternative is that investors were expecting financial Armageddon that never materialised and so are cheered by the signs that Europe is (finally) on the road to solving its problems.

There are no easy ways to discern the drivers, or logic, of recent market action, however for short-term traders there is no point standing in front of a moving train. Even if you think that Europe is going down, the euro is rising and bar an adverse shock it may continue to move back towards the 1.4000 zone. But what will the single currency do from there? 1.4000 is a major psychological level. There is no denying that things are different for Europe now: its banks are in trouble and some countries like France can’t afford to bailout their financial sectors without putting their credit ratings at risk, so is EURUSD above 1.4000 justified? Probably not, but the next few days will be crucial to see if 1, the euro can break back above this level and 2, how other risky assets react.

The FX markets are leading the way today. Stocks in Europe opened lower this morning, however, they soon caught a bid as the euro took off. The decline in the dollar has helped to push up gold and oil and other commodities priced in dollars. Asset markets remain tightly correlated, with equities, FX and commodities moving together. Right now FX is leading other markets, so if we start to see some weakness here it may be a lead indicator for weakness elsewhere.

Sterling is also enjoying a good run against the dollar; however it is weak among the other “strong” currencies like the euro and the Aussie after the highest unemployment reading for 15 years. There are now 2.57 million people in the UK out of work and in the month of August, 17,500 people applied for unemployment benefit.

The details of the report were shocking, youth unemployment increased to its highest level ever – 991,000 or 21.3% of people aged 16-24 are now unemployed. And there could be worse to come. BAE Systems announced it was closing a factory in the North that could lead to 3,000 job losses and the banking sector is also expected to cut its headcount over the next 12 months. HSBC and UBS recently announced job cuts in the region of 30,000. Although these cuts are worldwide, the UK’s position as a major financial centre means that the UK could lose finance jobs in the coming months adding more upward pressure to the unemployment figures.

This is a sticky situation for the UK government. It needs to stick to its fiscal consolidation plan to ensure the UK keeps its triple A credit rating, however further weakness in the jobs data will make this a politically hard plan to stick to. Overall, we think that the pound’s trajectory is lower, however it may hold up fairly well versus the dollar, especially if there is more QE on the cards.

We will get a better idea if the markets are right to expect QE3 from the Fed after tonight’s release of the minutes of its last when the US central bank announced Operation Twist. That sparked a dollar rally as investors digested the news that the Fed’s latest attempt at stimulus was not going to boost the size of its balance sheet. However, since then the commentary from the Fed has been fairly dovish. So watch out for any signs that more aggressive action will be taken as this would be good news for risk bulls.

Also worth watching today is the “Roadmap to stability” that will be presented by EU Commissioner Barroso at 1500 BST/ 1000 ET. The press release says that the proposals will be a “comprehensive crisis response.” One has to wonder why the EU hasn’t thought about doing this before, but for now the markets are happy that the cogs are moving to stabilise the situation. The Roadmap is due to be a wide-ranging document with details to help banks and Greece. This may well determine risk appetite as we head into the end of the week.

However, reports in the Irish press highlight how tough it can be to sort out public finances in Europe’s troubled states. A plan to forgive mortgage debt and wipe the slate clean would cost EUR14 billion. This is financially untenable, so less aggressive (and cheaper measures) will have to be adopted instead. The burden of bad mortgage debt is still very much the problem of the Irish government and thus the taxpayer.

Watch out for any comments about China and the US and trade wars. The US Senate passed a China currency bill last night, which has been met with some damning criticism from Beijing. The last thing the global economy needs right now is a trade war between the world’s two largest economic powers.