Blue skies giving way to cloud
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Blue skies giving way to cloud

The Financial Times leads today with the cracks in the EU Treaty agreement, but these were already evident even at the start of the week.

It seems remarkable that the other eurozone ‘outs’ (such as Finland, Denmark, Sweden, as well as UK and others) are only now asking themselves the obvious questions, such as whether budget rules will apply just to eurozone members or all EU members. Video:

It’s even more remarkable that there was not greater debate and questioning of this before the EU summit was agreed by all but one of the EU members. After all, the budget rules were drafted for the eurozone nations to avoid some (but by no means all) of the problems that led to the current crisis, so applying them in the same format to the ‘outs’ is a route towards domestic political antagonism.

As well as on budgets, there are issues around the European Stability Mechanism (Finland is unhappy that a supermajority is required to bail-out country), as well as the size of the ESM. The single currency slumped into the close yesterday as the cracks grew.

Guest post by FxPro


Key Fed guidance remains unchanged.   After its meeting yesterday, the Fed made no fresh policy announcements and kept its forward guidance on the economy and also policy unchanged. It was that little bit more bullish on the labour market, noting that “indicators point to some improvement”.   Furthermore, on inflation the Fed was more confident that it is contained, stating that it “had moderated”, rather than “appears to have moderated” as they said back in early November. In sum, the Fed appears a little happier with the real economy and inflation developments, but is wise to the fact that things can change quickly and that the wider global economy remains extremely fragile.

The ECB’s push on a string.   There continues to be a fractured money market with banks parking a record amount of cash at the ECB, unwilling to lend to those who, at the same time, have to borrow overnight from the ECB.   Of course a fair deal of the more recent stress is down to year-end, given the usual preference for liquidity over this period. But the continued divergence between Libor-OIS and EUR/USD basis swaps underlines just how much more the issue is concentrated in the euro money market. The announcement of further term funding (up to three years) in the eurozone money market allowed Libor-OIS spreads to narrow at the end of last week, albeit from 32mth highs. But also of note is the fact that EUR/USD basis swaps, which narrowed from nearly -160bp to around -110bp in the wake of the coordinated central bank action last month, have widened out again to around the 130bp level. So, around one third of the impact has already disappeared.   The accusation is that we are facing a solvency crisis, of which the liquidity issues are a by-product. That’s true, but it’s also an issue that is contributing to the higher costs of funding and working against the impact of the two cuts in interest rates from the European Central Bank. What remains curious and, has received little attention to date, is the ECB’s decision to cut reserve requirements from 2% to 1%. The thinking is that this would require banks to hold less cash with the ECB, allowing more to be lent out. But with banks holding substantially more than their reserve requirement at the ECB (more than twice more on average), then it’s difficult to see what material impact this will have. Once the year-end has passed, this will be worth watching to see what impact, if any, it has on bank’s preference to hold large amount of cash at the ECB. In all likelihood, it’s likely to be minimal, year-end distortions aside.

The India rupee’s dramatic collapse.  At a time when the global investment community is completely transfixed by Europe’s debt crisis and the potentially adverse consequences for the single currency, what has largely escaped attention up until now is the increasing pressure on Asia’s major currencies. Particularly noteworthy is the continuing collapse of the Indian rupee, which this week fell to a further record low against the dollar. Since the end of July, the rupee has lost more than 20%; since last Monday, the rupee is down nearly 4%.   It was not meant to be like this. India is one of the BRIC countries with massive growth potential. Some had earmarked India as offering greater risk/reward than China. However, so far this year, any dollar-based offshore investor has lost 35% on Indian equities. So, what has gone wrong? India’s affliction is shared by many of its Asian neighbours right now. Highly leveraged to global growth, foreign investors have been fleeing high-beta economies like India. Concurrently, domestic conditions have also taken a dramatic turn for the worse. In the year ended October, industrial production fell by 5.1%, almost matching the nadir reached in early 2009. The government’s fiscal position is deteriorating rapidly with the slowing economy weighing heavily on tax revenues. High oil prices are also wreaking havoc on the trade side – October’s trade deficit of almost USD 20bln was the highest for 17 years.   Although the rupee is certainly the weakest of the major Asian currencies, it is not alone. China’s policy officials are engaged in a massive arm-wrestle with foreign investors – the latter have been attempting to get capital out of the country consistently over recent weeks, with the yuan hitting the daily permitted low on each of the past ten trading sessions.

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