A dark day for Europe

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Another dreadful start to the new week for the single currency as investors and traders alike sought sensible levels to exit. The sense that Europe’s policy-makers are now in a full-scale flap over how to respond to this rapidly unravelling sovereign debt crisis was the principal catalyst for Monday’s negative price action amidst constant headlines of emergency and urgent meetings of European officials. Both Italy and Spain – two of the real elephants in the room regarding this sovereign debt debacle – once again experienced significant spread-widening as the contagion continued to deepen, with 10yr yields in both countries out by more than 40bp vis-a-vis Bunds at one stage; the 10yr Spain/Bund spread touched 335bp, while the 10yr Italy/Bund spread reached 300bp.

Europe’s other fiscal miscreants were not spared – spreads to Bunds for Greece/Portugal/Ireland and Belgium were out by 30bp, 40bp, 40bp and 20bp respectively. Bund yields maturing in 10 years were down more than 20bp at just 2.64%, and both gilts and US treasuries saw significant gains. The EUR has fallen further overnight to 1.3930 after losing 1.5% yesterday – for the month-to-date, it is down 3.7% against the dollar. Traditional safe-haven currencies are the major beneficiaries of this renewed uncertainty, with the Japanese yen and the Swiss franc leading the way, closely followed by the dollar. Equities are suffering, with some of the major Asian bourses down by as much as 2% overnight. Italy’s MIB index was down another 4% yesterday, a fall of more than 9% for the year-to-date, while some notable European banking shares such as ING experienced sharp falls of up to 10% yesterday.

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Commentary

European leaders fumble for fresh answers. Yesterday’s marathon meeting of finance officials failed to provide any real answers to Europe’s rapidly worsening sovereign debt crisis, reinforcing the perception that Europe’s leaders are still struggling to catch up with the pace of unfolding events. The statement released last night vowed to explore measures to enhance the flexibility and scope of the EFSF, potentially allowing it to buy bonds on the secondary market. Previously, both Germany and the Netherlands had blocked such a proposal. If Europe’s leaders believe that this will resolve the debt crisis, then their naivety is breathtaking. More analysis on this issue will follow later.

President Obama puts more heat on the GOP. With the President holding an unprecedented fifth press conference on fiscal issues and the debt limit within one week, he is clearly putting enormous pressure on the Republican Party to come up with a package that he and the Democrats can agree to. The debt limit deadline meanwhile is fast-approaching, with August 2nd now just three weeks away. For its part, the GOP are holding out against any tax rises whatsoever, a stance given more impetus after Friday’s horrible jobs numbers, while the Democrats are insisting that tax increases for the wealthy must form part of any fiscal deal, whether large or small. Obama is pushing for the most comprehensive deal possible, while the Republicans want spending cuts that are larger than any increase in the debt ceiling.

China’s policy vexations. Any economy with 1.3bn people is never going to be easy to manage, and in China’s case the policy challenge is becoming ever more complex. This past weekend reconfirmed just how tricky China’s policy dynamics are becoming. Consumer price inflation last month climbed to 6.4% YoY, up from 5.5% in the previous month and slightly above expectations. Food prices remain the main driver of inflation in China, up 14.4% in the year to June (food represents roughly one-third of China’s CPI basket). Non-food prices have been better behaved, up 2.9% over the same period, although a good proportion of this category is subject to price controls. Within non-food prices, housing is a major component (some 17% of the CPI basket), and it continues to accelerate, both because of rising house prices but also due to the increasing costs of renting. Rising energy costs are also contributing to the faster pace of overall inflation. For producers, inflation remains elevated as well, up 7.1% in the year to June. Separately, China’s trade surplus jumped to $22.27bn last month, up from $13bn previously, with imports falling 3% in the month and exports climbing 3%. The profile of China’s trade performance this calendar year is almost identical to that of 2010, namely small surpluses and even deficits in the early months of the year followed by decent surpluses through the summer months. That said, there has been a discernible slowdown in both export and import growth this year, with the former being dragged down by slower overseas demand, a stronger exchange rate and higher labour costs weighing on competitiveness. For China’s policy officials, these figures capture something of the policy dilemma they continue to face. Inflation shows little sign of abating just yet, despite the best efforts of policy-makers over recent months. The pressure of both strong internal demand and higher wages is clearly contributing to this inflation inertia, making it a difficult task to arrest. At the same time, China seems to be losing some of its competitiveness at a time when foreign demand is slowing. Beijing will need to continue to tread carefully as it tries to calibrate policy over the second half of this year.

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