Last week’s trading was reasonable for the end of the month with a little added volatility last Friday thanks to Ben Bernanke’s Jackson Hole speech.
Overall, the euro was pretty much flat, rising 0.50 percent to 1.2579. The EURO STOXX index was also flat, closing at 2,440. Bank stocks continued to rally though, adding 3 percent in the Dow Jones EURO STOXX banking index.
Goldman Sachs’s technical analyst John Noyce thinks that—after a significant rally—the euro will be driven by U.S. versus German interest rate spread move, as it retraced the previous discrepancy. Watching the interest spreads was a very good indicator last year and the economic theory behind it makes sense.
A significant deterioration in economic fundamentals in the eurozone will drive down German yields—as German bond prices rise inversely—reflecting a flight to safety bid. If the situation in the United States stays unchanged, yields in America will stay stable. Therefore, the difference between the two yields will increase, pushing the number, which is negative at the moment, down. Since euro fundamentals are worse than U.S. fundamentals, the euro will be sold, catching up to fixed-income fundamentals.
Economic Data Broadly Negative
The fact that the market did not go down is rather surprising, however, as the news flow was broadly negative.
The European Commission survey of economic confidence for August further decreased by 1.8 points to 86.1, a three-year low. Other economic reports for services and consumer confidence also declined markedly.
The unemployment rate also gives no reason for confidence, as it rose to 11.3 percent in July for the eurozone. This is the highest level since 1990, with peripheral nations hit the hardest, but German unemployment also saw a slight uptick albeit to still very decent levels.
Youth unemployment is particularly worrisome, especially in peripheral nations such as Spain, Portugal, Italy, and Greece. As of July, 22.6 percent of people in the workforce aged 25 and under where unemployed, an 18-year high.
Italy sports a rate of 35 percent, while Spain and Greece have rates as high as 53 percent. Germany’s is below 10 percent. This development is rather scary, as it takes hope away from the new generations and provides momentum to populist parties at the fringes of the political spectrum.
To make things worse, inflation in August also picked up from 2.4 percent to 2.6 percent compared to August last year. This was higher than economists’ expectations of a 2.5 percent increase and will make it difficult for the European Central Bank next week as inflation hawks remain vigilant.
The Week Ahead
All eyes will be on the European Central Bank (ECB) this week, as the ECB meets Sept. 6 to decide on additional policy measures.
Rumors have surfaced recently that the bank would engage in an all-out bond buying binge, setting a so called “yield-cap” for peripheral bonds without a limit on the quantity of the bonds it buys. This could end up being more extreme than the U.S. Federal Reserve’s quantitative easing (QE) programs, as QE1 and 2 had a fixed limit attached to them.
The yield cap program that was discussed in the media—mostly in reports citing unnamed sources—would see the ECB set a maximum yield on most peripheral bonds like Spain. If the ECB were to set a cap at 6 percent for the Spanish 10-year bond for example, it would buy all bonds that were tendered at a yield above 6 percent, potentially taking a majority of Spanish debt onto the central bank’s balance sheet.
ECB President Mario Draghi has also hinted that he would support such a program, although his language was vague and he always insisted that he would stick within the mandate of the central bank.
While easing the financing burden on the troubled countries, it also carries significant risks, especially for fiscally sounder countries such as Germany, the Netherlands, Finland, and Austria.
It would give peripheral nations carte blanche to keep issuing debt without reforming their economies, which ultimately is guaranteed by the creditor nations through the ECB. This is why officials such as Bundesbank’s President Jens Weidmann have been in staunch opposition to this plan and it was reported in German media that Weidmann has German Chancellor Angela Merkel’s backing.
Major investment banks also don’t believe that unlimited bond buying will be announced at the next meeting. Morgan Stanley commented in a report: “We don’t believe that the conditions for the ECB to start buying government bonds are likely to be met already at the upcoming Governing Council meeting on September 6.”
What the ECB can do without upsetting creditor nations, however, is what Citigroup predicts in a note to clients, “We believe that the ECB will have little choice but to lower its main policy rate by 25 bps to a new low of 0.5%.”
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