Merkel shows a softer side

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It was a case of the glass being half-full yesterday, as those with short positions in risk assets and currencies scrambled for cover. In the single currency, there was healthy buying interest all through the day, with the euro trading through 1.27 at one stage.

The more positive mood would no doubt have been helped by a Dow Jones story claiming that Eurogroup head Juncker had suggested that a Greek bailout extension could be discussed. It was unclear whether he had cleared this with Mrs Merkel, but nevertheless it added to this growing sense that Germany is less in control of the direction of European policy-making these days.

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In Greece, there was optimism that a three-party coalition government could be formed relatively quickly, with its first major task the renegotiation with creditors of the terms of the bailout. Elsewhere, there were numerous reports that European leaders at the G20 Summit had agreed to permit both the EFSF and the ESM to buy Spanish and Italian debt in quantity. This resulted in significantly lower bond yields yesterday – indeed, the 10yr spread of Spanish and Italian bonds to German Bunds narrowed by around 25bp on the day. Thus far, these reports from Los Cabos have not been substantiated by European leaders; Italian Prime Minister Monti denied that such a deal had been struck. There was also a dollar dimension to the euro’s strength, the growing speculation that the Federal Reserve may well announce an extension of Operation Twist as soon as tonight. European equities swooned, climbing by around 2%, and the Aussie dollar reached 1.02.

Commentary

More grounds for extending UK QE. Good news on UK inflation has been rare in recent years.  Since early 2008, the increase in the overall price level (of 16%) has been around double that seen in both the US and eurozone and the Bank of England governor has been busy writing letters every three months to explain his actions (or lack of them) to the Treasury. So, the decline in May to 2.8% (from 3.0% in April) means that the Governor can at least put his pen away. Furthermore, there should be some more good news to come.  The main upward pressure in May came from air and sea transport, not a huge component of the CPI, but very volatile owing to the calculation methodology (and to the different timing of Easter), so there is a fair chance that this upward pressure will be unwound in the June data. The key question is whether this will pave the way for further quantitative easing from the BoE in the near future. Speaking last week, the Governor appeared more amenable to this, but also acknowledged that there had been issues with the effectiveness of past QE episodes, in realising an impact on borrowing costs for both households and businesses.  This underlined the activation of the Extended Collateral Term Repo Facility together with the ‘funding for lending’ program being worked upon with the Treasury. The emphasis appears to be on increasing the effectiveness of monetary policy, rather than simply doing more of it.  This could well mean that near-term expectations of more QE are disappointed, but more QE appears likely by the August meeting. There was little surprise to see sterling weaker on the news, but the reaction against both the euro and dollar has been relatively modest, with most of the initial weakness subsequently reversed.  Currency markets are becoming more aware that further QE will not have the same impact as past episodes and anyway, on the majors (AUD aside), central banks are all playing a very similar game.  Another counterbalance is the on-going eurozone crisis, which has seen sterling benefit in the wider picture. Whilst the euro may still be susceptible to short-covering rallies, the current period of consolidation of EUR/GBP may not last long.

Aussie bulls still in control. June has been a very successful month for Aussie bulls, following the severe battering suffered in May. After plunging below 0.96 on the first trading day of the current month, the AUD has since traded higher consistently, now around 1.02. Over the past couple of trading sessions the Aussie has easily penetrated the 50d moving average and looks poised to attempt a run on the 200d moving average, currently around the 1.0250 level. Both domestic and international forces have contributed to the Aussie’s improved fortunes. Firstly, after accumulating record short positions in the Aussie at the end of May, traders and short-term speculators have scrambled to cover as the currency has abruptly changed direction. Secondly, domestic fundamental news has been more favourable than expected. First quarter GDP soared by more than 1% and jobs’ growth last month was quite robust. After lowering rates in both May and June, yesterday’s RBA Minutes suggested that the Bank is in no hurry to deliver any further monetary medicine for a while. Although the RBA still has an easing bias, these Minutes scuppered expectations at the front end that they might be disposed towards a further relaxation in the near term. Thirdly, the ranks of the AAA-rated sovereign universe are thinning out rapidly and many investors harbour justifiable doubts over some of those who have managed to hold onto the top rating (such as the US and the UK). By contrast, as Moody’s made clear recently, Australia remains one of the world’s strongest sovereigns, with very low government debt, strong institutions and healthy overall financial strength. Evident over the last couple of weeks is that the currency has benefitted from some very large orders from foreign money managers keen to avoid the perils of investing in the major currencies. For now, the Aussie bulls are riding roughshod over the bears.

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