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If European leaders hoped that the progress they had made over the weekend might help to placate investors and traders, then Monday’s price action should send them back to the drawing board. After reaching a high early on of 1.3954, the euro fell back by more than one big figure by late morning as the consensus developing was that Europe’s policy-makers were still two steps behind. Bond spreads for troubled sovereigns continued to widen relative to German bunds, with the IT/GER 10yr government bond spread out another 13bp to 390bp at one stage. France is not off the hook either – the FR/GER 10yr spread widened another 5bp to 118bp.

European leaders made a brave fist of attempting to resolve their differences over a solution to the worsening sovereign debt and banking crisis over the weekend, but unfortunately it appears that they will again underwhelm when they announce details of their response on Wednesday. In some respects, such is the incredible pace with which underlying circumstances are shifting that Europe’s key policy-makers are struggling to catch up. Indeed, one is reminded of the little boy using his fingers to attempt to plug holes in a dike – eventually, he runs out of fingers, and, even worse, his fingers just aren’t big enough to fill the holes.

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Most critically, some progress has been made on raising the EFSF’s firepower but plans are at a very early stage and could still unravel. On Saturday, eurozone finance officials were shocked to learn that the size of the fiscal black hole in Greece could be as much as EUR 252bln between now and 2020 unless bond-holders can be convinced to share the burden. This would absorb virtually all of the EFSF’s remaining financial resources, leaving almost nothing for any other bailouts, secondary bond-market purchases or banking recapitalisation. In essence, as succinctly stated by the Dutch Finance Minister, European leaders need “to get real” about increasing the size of the bailout facility.

Talk that the EFSF could set up an SPV designed to attract funds from the IMF, BRIC nations and/or sovereign wealth funds are somewhat reassuring, and one of the major sources of optimism to come out of the weekend gab-fest. Without non-European participation in the EFSF, European leaders seem incapable of finding a way to properly supply the facility with the funds that it so desperately requires.



Europe’s darkening growth picture. At a time of extraordinary uncertainty regarding the future of the euro project, it is perhaps no surprise that economic decision-makers are battening down the hatches just in case. Yesterday’s PMI data for October confirms that the growth picture in Europe continues to darken. For the eurozone, the composite PMI fell to just 47.2 this month, with both manufacturing and services down sharply once again. Germany, previously Europe’s growth saviour, is being dragged down into the mire, with the manufacturing PMI falling below 50. This latest growth shock further weighed on the euro yesterday when it was already under pressure on other fronts. As we mentioned in a separate blog piece yesterday (see, the perception is that, while European leaders did move forward over the weekend, they remain well behind the curve. Without giving the EFSF a massive injection of firepower, any announcement made on Wednesday is likely to be viewed as inadequate.

Japan’s currency threats become even more audible. Clearly shaken by Friday’s sudden lurch in USD/JPY down to a new record low below 76, Japan’s new finance minister threatened further “decisive action” yesterday and again overnight. Azumi was remarkably animated, declaring that the latest move was “utterly speculative” as well as not based on fundamentals, regrettable and excessive. He also reaffirmed that the strength of the yen was hurting the export sector (the trade figures released on Monday actually suggested that exporters were at least coping with the strong currency relatively well). As we suggested last week, the MoF’s determination to stabilise the yen this year has been unwavering. Furthermore, senior industry leaders have been warning the government for some time that the elevated level of the currency would impact on future decisions about the location of business, production facilities, etc. Although unilateral action often fails to have anything other than a fleeting impact, nevertheless the MoF is clearly poised to undertake intervention. In Japan’s case, it has both the willing and the firepower, having recently tripled the size of its intervention fund.

The clamour for more Fed QE. One of the reasons for the weakness in the dollar over the past couple of weeks is growing speculation that the Fed will be forced at some point reasonably soon to expand the size of its balance sheet. Last week we had two senior Fed officials, including Fed Vice-Chairman Janet Yellen, intimate that this was a distinct possibility. Yellen rightly claimed that another round of quantitative easing may well be needed in order to boost an economy stuck with an unacceptably high unemployment rate of over 9.0%. In addition, there is also a concern over how the economy performs in 2012, with fiscal policy set to subtract at least 1.5 percentage points from growth. Any balance sheet expansion may well include an increase in mortgage purchases, because the Fed would recognise that lowering mortgage costs can act as a powerful stimulant for the economy. Fed Governor Tarullo made exactly this point last week.