FX Briefing – EUR-USD: Balance of terror

Highlights

 

 Fears start spreading to Italy, Italian bond yields soar

 US parties still at odds, time for agreement is running out

 Euro finance ministers discuss private sector involvement, bond buybacks

In the wake of the heavy losses suffered by Italian government bonds, the euro also came under pressure at the beginning of the week. EURUSD broke out below the past months’ trading range, tumbling as low as 1.3838 on Tuesday morning – its lowest level in about four months. During the course of the week, however, the euro recovered significantly; at the end of the week, it was trading at about $1.4150, only a good cent below the previous week’s level.

 

The euro’s strengthening was not solely on its own merits, however. Admittedly, money market rates in the eurozone are much higher than in the US, particularly since the last ECB interest rate rise, which is supporting the euro. But uncertainties over the debt crisis are cancelling out this advantage, particularly when fears start to spread from the periphery to the core. But even though the Italian government made a noticeable effort to dispel doubts about political support for finance minister Giulio Tremonti and his austerity measures, Italian government bond yields and their spreads over German Bunds have not fallen significantly in the last few days.

 

This sustained mistrust is mirrored in the forex market in the assessment of the euro against the Swiss franc. Parallel to the escalation of the situation on the Italian bond market, EURCHF fell from around 1.21 at the end of last week to about 1.15. EURCHF ended the week just slightly above its historical low, at about 1.1550. The euro’s strength against the dollar was not mirrored in the Swiss franc rate. In other words, the euro was able to gain ground against the dollar because the dollar is being eyed with the same mistrust as the euro.

 

US budget conflict: chicken game

The negotiations on budget cuts, which form the basis for raising the debt ceiling, have not yet led to any agreement. At least one group of Republicans refuses to compromise on the subject of tax increases. Neither the Democrats nor the Republicans can back down in this “chicken game” without losing face.

 

Meanwhile, both Moody’s and S&P have threatened to downgrade the US credit rating if the US fails to meet its financial commitments because of the debt ceiling. A decision must be reached next week so that the legislative procedure can be completed by 2 August. If this does not happen, the US government will not be able to meet its financial commitments in August.

 

The dollar’s weakening trend was reinforced by comments made by Fed Chairman Ben Bernanke in his semiannual testimony on monetary policy before the House of Representatives, which were initially interpreted as a signal that the Fed may implement further quantitative easing measures. Mr Bernanke attempted to correct this impression the following day, however. In his testimony to the Senate Banking Committee, he pointed out that the Open Market Committee was not planning QE3 at present.

 

Rapid solution for Greece

In our view, the main source of growing concern is the lack of clarity over the Eurogroup’s next moves to bail out Greece. The statement issued by eurozone finance ministers at the beginning of the week and the latest IMF report reveal that private sector involvement has now become a key element for resolving the problem. The IMF review states that “comprehensive private sector involvement is appropriate given the scale of financing needs and the desirability of burden sharing”. The finance ministers seem prepared to risk that the rating agencies – which are leaving policymakers hardly any room for manoeuvre here – could regard this as a default. They are also prepared to defy the ECB, which is strictly opposed to any measures which could be classed as a payment default.

 

The eurozone countries appear to be examining various courses of action, however. Evidently, the possibility of buying back bonds is under serious discussion. German finance minister Wolfgang Schäuble has just said that “one solution” would be for Greece to buy up its own bonds with EU funds. The German government had up to now rejected this idea in order to maintain political pressure to consolidate public finances in Greece. But Mr Schäuble is still opposed to eurobonds, i.e. bonds jointly issued by the Eurogroup.

 

The surge in Italian government bond yields has made it clear to all concerned that time is short. A sensible plan for Greece could help not only Greece but also the other peripheral countries, for which the Greek bailout package would presumably serve as a guideline, should

 

Exchange rate risks across the board

A sort of balance of terror between the US and the eurozone is helping to keep exchange rate relations between the two currencies relatively stable. In this environment, it is almost impossible to recommend one or the other. If, as is to be hoped, a reasonable budget agreement is reached in the US next week, this should support the dollar. Vice versa, if the aid package for Greece makes tangible progress, the euro could benefit. But miracles generally take a bit longer.

 

 

Economics Department

+49 69 7183642

volkswirtschaft@bhfbank.com

Foreign Exchange Trading

devisenhandel@bhfbank.com

Matthias Klein

+49 69 7182175

Matthias Grabbe / Klaus Näfken

+49 69 7182146 / 2683

 

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