The gloves are coming off

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Most worrying for the single currency during this summer hiatus is that the nature of the dialogue between Europe’s major policy-makers has become increasingly acrimonious. In an interview with Der Spiegel yesterday, Italian Prime Minister Monti warned of a “psychological dissolution of Europe” because of the ongoing tensions in the eurozone over recent years.

Monti remains vexed by Bundesbank opposition to the recommencement of secondary bond market purchases by the ECB, as mooted by ECB President Draghi last week. He also called for national governments essentially to override national parliaments when considering decisions on Europe’s financial crisis, in a veiled criticism of the power of the Bundestag.

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Both Monti and Spanish Prime Minister Rajoy are under extraordinary political pressure within Europe to apply to the rescue funds for a bailout, a condition stipulated by Draghi for the recommencement of SMP. However, Monti and Rajoy remain reluctant to apply because they fear the conditionality that will be imposed on them by both the rescue funds and the ECB. Indeed, both are railing against being pressured into bailouts, hence Monti’s latest outburst. For their part, German politicians are equally unequivocal, with Foreign Minister Westerwelle yesterday claiming that “the tone of the debate has turned dangerous…we must be careful that Europe does not rip itself apart”. Unfortunately, that is already happening.

Commentary

Less safe sterling. Sterling was one of the weakest performers of the majors last week, adding to the perception that it is losing momentum as a simple by-product of not being in the eurozone. It has always been a stretch to label sterling a safe-haven currency, but there is no doubt it has benefitted from events in the eurozone, with the strong performance of the bond market and the bid tone in high-end central London property evidence of this. This has allowed it to bypass the debate about the performance of the domestic economy and also the impact of the government’s austerity program. That’s getting harder though. Even though the 0.7% decline in output in the 2nd quarter was down to some one-off factors (most notably one extra day’s holiday), the government was far less inclined to blame it on events elsewhere, such as the eurozone crisis. This week the Bank of England will once again have its say with the publication of the latest Inflation Report. The May report saw inflation for the year-end revised up nearly 1% vs. the February projection. If anything, inflation has fallen below expectations, but the Bank is unlikely to instigate a large downward revision as some of the inflation fall was down to the early timing of sales and as the outlook for food prices looks to be modestly bearish in light of poor harvests (seen and to come). Perhaps the biggest point of interest for Wednesday will be the extent to which the Bank talks about other policy measures. In recent months, the minutes have shown a greater debate around the possibility of cutting rates, whilst the Bank remains keen to see some results from the recent Funding for Lending scheme.  For now, the recent increase in EUR/GBP is likely to be sustained as the safe-haven story loses steam.

Beijing weighs up more currency depreciation. With the economy still struggling to re-establish momentum, policy officials in China may continue to allow the currency to depreciate in coming months. According to a commentary piece in yesterday’s China Securities Journal, a weaker exchange rate would take some of the heat off monetary policy. At a time of soft global demand and rising pressure on competitiveness, exporters would clearly welcome some additional currency relief. Allowing the currency to decline further would also help to stabilise inflation expectations; some local economists in China expect that the inflation rate fell to just 1.7% last month, down from 2.2% previously (the next CPI is released on Thursday). China still has considerable policy firepower at its disposal, in sharp contrast to the situation in many of the world’s advanced economies. Currency depreciation is just one of those options. In a US presidential election year however, policy-makers will need to tread carefully to ensure that America’s trenchant opposition to China’s approach to currency-management is not reawakened. In this regard, it is just as well that the US economy is registering some growth at least, as last Friday’s payrolls figures confirmed. We can also expect further cuts in both key lending rates and bank reserve requirements in coming months, as well as additional fiscal initiatives.

A big week for Aussie bulls. One of the wonderful characteristics of the Aussie from a trading perspective is that it is often subject to significant changes in direction over relatively short periods of time. Over the past two months, the AUD has jumped by more than 10% against the dollar, after an even more pronounced 13% dip over the previous three months. To put this into perspective, this is the 6th occasion over the past year when the Aussie has experienced a move of 10% or more in either direction. And yet, despite this apparent volatility, the AUD has actually remained in a relatively tight range; since August last year, the low for the Aussie has been 0.94 while the high has been just above 1.08, in percentage terms just 15%. With the (wonderful) benefit of hindsight, a trading strategy that would have delivered handsome profits over this past year would have been to buy at around the 0.97 level and sell at around 1.06. Interestingly, the AUD is back close to the top end of this range just after the start of a fairly critical week. Signs over recent weeks that previous rate cuts were helping the economy ensured that the RBA would decide to sit tight on monetary policy when it met overnight. Of greater import will be Thursday’s jobs figures, followed by the RBA’s Statement of Monetary Policy on Friday. The local economy is still being adversely affected by a strong currency, weakening external demand and consumers reluctant to open their wallets given the uncertain international backdrop and falling property prices. Traders have completely altered their stance on the Australian currency – they are now constructively bullish with decent long positions after accumulating a record short position at the start of June. Just as it has done over the past twelve months, it is entirely plausible that the air will get thinner for the Aussie at these elevated levels.

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