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FX Briefing - Euro remains under pressure

FX Briefing 26 November 2010



Euro continues to fall on fears of contagion spreading

Macroeconomic outlook suggests normalisation of ECB monetary policy to proceed


Euro remains under pressure

The single European currency is continuing to slide in the forex markets. Towards the end of the week, EUR-USD fell to 1.32 temporarily. Apart from the US dollar, the main winners are the Canadian and the New Zealand dollars, but also the pound sterling, the Australian dollar and the Asian currencies.


The euro’s decline reflects growing fears that the rescue package for Ireland might not be enough to stop the sovereign debt crisis in the eurozone from spreading. Yield spreads between government bonds in the so-called peripheral countries and German bunds have now widened to new records. 10-year Spanish bond yields are almost 250 basis points higher than their German counterparts.


However, given the doom and gloom scenarios envisaged by the bond markets, the euro’s losses are still relatively harmless. It is currently around its average level for 2010. Bond markets are nervously discussing crisis scenarios in which first Portugal and then Spain need to be rescued. Depending of course on how much is actually needed, the rescue mechanism might not be big enough to cope with a Spanish bail-out, as the potential financing volume of the European Financial Stability Fund (EFSF) is lower than the nominally guaranteed €440bn. This is because a country requesting aid cannot give the EFSF a guarantee commitment, and the AAA rating stipulates over-collateralisation of the emission volume.


These scenarios would become even more dramatic if the banks of these countries were to be dragged into the crisis maelstrom. Due to the housing crisis, the smaller Spanish banks in particular are not totally immune, and investors’ reluctance to buy government bonds is raising the refinancing costs for these banks too, making the potential financing requirements higher if a rescue were necessary.


Another reason for concern is that the Irish government does not appear to have the parliamentary majority necessary to pass the austerity package unveiled on Wednesday. Two independent members of parliament said they would not vote in favour of the National Recovery Plan, so there might not be enough votes to pass the bill. Furthermore, the Green Party has announced that it will quit the coalition government at the end of the year.


Against this backdrop, prime minister Brian Cowen has pledged to call a general election in the new year, but after the austerity budget has been passed and the negotiations with the EU and the IMF have been concluded. He is counting on the opposition parties not blocking the (possibly modified) austerity measures, and he could be right: realising that there is no alternative, bowing to pressure from Brussels, and enticed by the prospect of a general election, they could well give in.


Berlin is not helping to calm things down either. Heads of state and government are due to discuss establishing a permanent rescue mechanism at the EU Council meeting on 16 and 17 December, and in this connection, the German government is calling for private bondholders to share the bur den when a country requests aid from the permanent (!) rescue mechanism.


The German government’s demand for private bondholders to share the burden does not apply to the present rescue measures. The German government has probably started this discussion now, at the risk of rattling the markets, in order to put pressure on its EU partners to make the necessary political decisions in the EU Council and at the same time to speed up the austerity measures in the troubled countries.


However, discussions about the debt crisis are now becoming irrational in some cases. The fiscal situation in Spain is in fact not all that critical at the moment; in relation to some other industrialized countries, e.g. the USA and the UK, its deficit and public debt ratios even seem quite modest. Moreover, Spain and Portugal do not have oversized banking systems weighing on public finances.


Furthermore, the eurozone rescue mechanism in its present form is not the only option open to the eurozone. Even if Spain were to face financing problems as a result of growing fears, there are still political options available apart from debt restructuring. Bundesbank president Axel Weber, for instance, stated that if the worst came to the worst, the rescue fund would have to be increased. But in that case, the ECB would probably be forced to intervene too.


One positive factor is that the macroeconomic environment in the eurozone has improved on the whole. The OECD, for instance, is predicting growth of 1.7% in the eurozone in 2011, and 2.0% in 2012. Germany will continue to drive growth, but other countries will also play a part. Spain, for example is set to return to growth in 2011.


ECB: Normalisation despite debt crisis

The ECB often uses the last meeting in the quarter to examine its monetary political stance in more depth and to send markets a signal of what is to come in the next quarter. This is because the new macroeconomic staff projections have usually just been released then. An additional reason this time is that the ECB’s commitment to full allotment of its refinancing operations is due to expire. In the last few weeks, several ECB representatives have made it clear that normalization of monetary policy is to proceed. Even the Spanish central bank president, who could perhaps be thought to be biased towards loose monetary policy at present, has spoke out in favour of this.


We are expecting the macroeconomic picture to underpin the tendency to move away from loose monetary policy in the eurozone. The growth forecast (taking the middle of the forecast range) for this and next year in particular are likely to be revised upwards. Moreover, the inflation forecast for 2012 – i.e. in the medium term – could reach the ECB’s target of just below 2% again for the first time. This plus the ongoing economic recovery, will make it difficult for the ECB to justify maintaining the present very accommodative monetary policy.


Against this backdrop, we think it likely that the ECB will abandon full allotment of long-term refinancing operations and offer variable-rate tenders instead. It could seek a similar solution for its weekly refi operations too.

Stephan Rieke +49 69 718-4114




Economics Department

+49 69 718-3642

[email protected]

Foreign Exchange Trading

[email protected]

Matthias Klein

+49 69 718-2175

Matthias Grabbe / Klaus Näfken

+49 69 718-2146 / -2683


This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.


The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results.


This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it.


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