Euro becomes a pariah

Now becoming apparent is the degree to which investors and traders have been abandoning the euro over recent weeks. According to the CFTC, euro shorts have been substantial over the past month; only in the second quarter of last year were traders more negative. It also turns out that investors have been fleeing the single currency with similar vigour. Real money managers polled by BNY Mellon reported a huge reduction in euro-exposure in 2011, at a pace twice that of last year. Separate surveys undertaken by some of the major investment banks all confirm that foreign investors have significantly reduced European bond and equity investments over recent weeks.

Interestingly, the IMF reports that sovereign wealth funds have also been lowering their euro-exposure, favouring the Japanese yen, the Aussie and the Canadian dollar. To add to the almost unanimous pessimism towards the euro, the overwhelming expectation of analysts polled by Bloomberg is for the euro to depreciate before year-end. To summarise then, the euro is gripped by a sovereign debt and banking crisis which very few believe Europe can resolve and traders and investors have supposedly fled the currency – it is universally despised. So, it seems reasonable to ask the following: if there has been such an incredible volume of euro-selling, why is the single currency not much lower?

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At almost 1.39, it is only fractionally under its average for 2011 (1.4032). From a fundamental perspective, it is perfectly understandable to harbour deep suspicions over Europe’s ability to resolve its difficulties. However, many other major advanced economies face very similar problems. Moreover, the consensus on the single currency is overwhelmingly negative. For the euro-bears, the danger signals are flashing – if Europe does cobble together a decent package in the near term, there is enormous potential for a short-covering rally.



China’s slowdown triggers a new bout of risk aversion. News that Chinese GDP slowed to a weaker-than-expected 9.1% YoY last quarter triggered a fresh bout of risk aversion overnight, with the major Asian bourses down generally 2-3%. Tighter financial conditions, a debt overhang, falling property prices and Europe’s debt crisis are all weighing on growth. Money supply growth last month was the weakest for almost ten years, and lending growth is softening. Land sales are declining, as are house prices, and export growth has weakened markedly. That said, some caution is required before getting too pessimistic about China’s growth performance: for the quarter, GDP growth was still a very respectable 2.3%, down from 2.4% in Q2. Also, industrial production rose nearly 14% YoY in September, and fixed-asset investment boomed nearly 25% in the first nine months of the year. Although the monetary policy task for China’s leaders is much more finely nuanced these days, it is in a very strong position with plenty of choices. At the very least, policy-makers can be confident that changes (to policy) will have some impact, in contrast to the situation in many of the world’s largest advanced economies these days.

A very big week for Europe. Europe got the blow-torch treatment from the rest of the G20 over the weekend, with international leaders emphasising that a comprehensive plan for resolving the eurozone sovereign debt and banking crisis must be delivered by next Sunday’s EU Summit. Interestingly, some of those who have been admonishing Europe consistently over recent weeks seemed encouraged by the progress made recently. For instance, Tim Geithner proclaimed that the strategy Europe was now pursuing contained the right elements, notably the recapitalisation of Europe’s banks, expanding the firepower of the EFSF and reducing Greece’s unsustainable debt mountain. Agreeing on a comprehensive plan for recapitalising the banks over the next week will be a monumental task, although it appears that there is more accord on how to increase the EFSF’s firepower – allowing the fund to offer partial insurance for buyers of the bonds of distressed European sovereigns. Merkel attempted to hose down expectations of a breakthrough yesterday, saying (through a spokesman) that attempts to resolve the crisis will extend well into next year and that banking recapitalisation was on the agenda for this Sunday. The single currency retreated in response. Germany and some of its northern European partners continue to push hard for greater private sector involvement in Greece’s rescue program than was agreed back in July. Although there has been some pushback from the ECB, France and some investor groups, it is inevitable that the private sector will be asked to share more of the burden. That said, it will not be any easy process, because France and the ECB are still insisting that any haircut must be voluntary otherwise it would constitute a default and result in other potentially unpleasant consequences. Also, the IIF (Institute of International Finance), which represented international creditors in the July negotiations, has claimed that investors are not prepared to accept a greater haircut and do not want the July deal reopened. Greek banks would obviously be heavily affected should they be required to write off more of their Greek debt holdings. Over coming days, we can expect some very spirited and animated conversations on this subject. Critical will be Thursday’s report from the EU/ECB/IMF troika on Greece’s fiscal situation. It promises to be another week in which Europe’s response to the crisis will completely dominate the financial news.

The dollar’s relationship with data. After last week’s stronger US retail sales data, it’s interesting to look at how the relationship between the US dollar and the strength or otherwise of domestic data has shifted. From the highs made at the start of the month, we have seen the dollar index down nearly 4% as appetite for risk has returned to markets, or at least the shorts built up in risk assets have been reversed. But when comparing the dollar’s performance with what we’ve seen on the Citigroup Economic Surprise Index, the decline looks to have been fairly modest so far. The Surprise Index measures the degree to which economic releases are coming in above or below expectations. More recently, the series has been on an upward trend, which equates to activity data coming in above expectations and price data falling below. For most of the past four years there has predominantly been an inverse relationship between the dollar and data surprises – data coming in below expectations, weakening the dollar and vice versa. The 3mth rolling correlation between the two series has just moved into positive territory for the first time since April of this year. This reflects the fact that, although the data has been better than expected, it has not delivered the required push to risk appetite and the move away from dollar that would normally be expected. The change in behaviour reflects the extent to which it is sovereign risk factors that are now driving risk sentiment, far more so than the dynamics of the US economy.

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