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Blind faith in European politicians is worrying at the best of times.
But, it is particularly worrying now.
The euro is staging a remarkably strong rally as investors assume that, although Greece might yet default on its debt, European politicians are prepared to prevent a larger crisis from enveloping the single currency.
This improved sentiment towards the euro has been gaining momentum over the last week or two, as members of the euro zone have gradually been following Germany’s lead and ratifying reforms to the European Financial Stability Facility, that will provide bailouts to peripheral debtors.
Evidence of the creeping faith came in data from the currency futures market in Chicago last Friday, showing that although short speculative positioning in the single currency remains high, these position’s have stabilized in the last couple of weeks.
In other words, speculators are not quite as anti-euro as they once were.
The big upward move in the euro came, however, after a summit meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy last weekend at which they pledged to come up with a “comprehensive” plan to resolve the crisis by the time G-20 leaders hold a meeting in early November in Cannes.
The thing is, Ms. Merkel and Mr. Sarkozy gave no details of their plan and with Mr. Sarkozy still giving no explicit support to German proposals for recapitalizing European banks, the two leaders have essentially asked financial markets to just trust them.
And believe it or not, the markets are doing this.
Of course, background sentiment has been helped by signs of an improved global economic picture. Equity markets have been showing signs of recovery, boosted by the improvement in U.S. employment data last Friday and by hopes the U.S. third quarter earnings season that gets underway shortly will reflect at least a small upturn.
But, euro investors are still being asked to put quite a lot of blind faith in the political process and they could find this is all misplaced.
Fear of contagion among peripherals remains high with the rating agency Fitch downgrading both Italy and Spain and putting Belgium on notice for a downgrade, as it struggles to resolve the problems of one of its largest lenders, Dexia.
Next, there is the issue of the EFSF ratification, which could well run into trouble when the Slovakian parliament holds its vote, as well as the outstanding report from the so-called Troika on Greece’s budget deficit plans, which will doubtless confirm that the country will have to default.
On top of this, there is likely to be more of the recent steady trickle of negative news from the euro-zone economy indicating that while there are improvements in the wider global economy, the euro zone itself is still slowing.
All this suggests that while blind faith in European politicians may be holding for now, helping to push the euro up over $1.35, the single currency could still end up heading back down towards $1.30 as it did earlier this month, if politicians don’t start living up to their promises soon.
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Mr. Hastings, did you forget your College FX classes? Currencies tend to follow a simple rule (at least partially): the interest rate diferential explains a lot of the FX moves. The market was expecting a slash in the ECB refi rate last week, that did not happen, and apparently will not happen in November either, so a cash deposit in EUR still yields a lot more than in USD. Maybe it is not more complicated than that…
Maybe market participants are also seeing something else:
1. A lot of individual governments are taking measures, which are shoring up their countries’ individual finances. As an example:Irish, Italian and Spanish bond yields have been falling (Irish now below 8% (from 14%), Italian bonds around 5,5% and Spanish closed last week below 5%, with little ECB support over the last 3 weeks, so those are starting to look like “real” yields again, showing a slow but certain return of market confidence. Portugal’s yields aren’t falling, but the country does have a government that seems determined to solve its structural issues – and has received a mandate to do so from the electorate.
2. Today’s rally is in part the unwinding of the end-of-week scare of Italian/Spanish downgrades. Apparently, the weekend has given market participants time to think about this and they too have realized that credit agencies are – once again, or maybe “still” – hopelessly behind the curve on this thing. As witnessed by roughly steady Spanish (especially so) and Italian rates.
3. The fact that this has turned into something of a banking scare makes it more difficult, but also easier to solve, since it means countries can tell their populations that they are “saving citizens’ savings” rather than “bailing out Greeks”. This will probably end up with countries handing out (or selling) a bunch of guarantees and ratings agencies have already shown they don’t take those into account much (see the UK’s credit rating for proof on this)
Not saying this will be over quickly – and it shouldn’t be over quickly. You cannot solve problems that took years to create in a few weeks, so pretending it was possible would more than likely only be papering them over and guarantee that they’d come back with a vengeance.
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