Last week’s passage of the Eurozone financial rescue plan will impact currency markets this week as traders continue to evaluate its worth. The markets will also be watching the Fed for any news about a QE3 initiative.
As expected, European Union (EU) leaders came up with a sufficiently credible plan to prevent a disorderly default of Greece, recapitalize EU banks, and increase the size of the European Financial Stability Facility (EFSF) in an attempt to quell contagion to other EU sovereign debt.
Risk markets responded with a massive rally on what we think is overexuberance, but also likely due to a huge squeeze on short-risk/long-US dollar (USD) positions. The details of the EFSF expansion, the Greek debt swap, and other mechanisms are still to be worked out over the coming weeks, but market sentiment over the package appears to be fading rather quickly.
No less of an authority than the new president of the Bundesbank, Jens Weidmann, has already called the EFSF expansion into question, telling a conference in Munich the plan is “Not too different from those which were partly responsible for creating the crisis, because they concealed risks.”
His comment hits at the critical issue behind the Eurozone debt crisis; namely, that it’s all about confidence and perception. If markets believe the plan is credible, then it may not even be needed. But if markets don’t buy the notion that more borrowing will solve Italy’s already overextended debt, then even the expanded EFSF won’t be sufficient.
Ultimately, that comes down to growth prospects for the individual debtor nations, and there we think the prospects are daunting to say the least.
European credit markets appear to be already voting with their feet, as core peripheral bond spreads have begun widening again after a mere 24-hour respite. Italian ten-year government bond yields are back over 6%, and Spanish bond yields have reversed their declines from the post-summi! t euphor ia.
US Treasuries rallied on Friday on safe-haven demand, sending ten-year yields lower by about ten basis points (bps) in a potential failure/rejection above the daily Ichimoku cloud.
US stocks look to have stalled for the moment, with the S&P 500 possibly topping below the peak of the 1290 weekly cloud/1300 psychological resistance levels.
Across markets, the rebound in risk assets this past week basically closed the gap from the collapse that started in August (in stocks) and the surge in the USD that started in early September.
While there has been some potentially serious technical damage done to the risk-off trade, we think we’re more at a crossroads than a major turning point. We will be especially alert for indications that the risk rebound is reversing this week. We think the Federal Open Market Committee (FOMC) will need to deliver QE3 for gains to continue (see below for more).
Back to the EU debt crisis; in the weeks ahead, we think there is likely to be a fair amount of cheerleading for the EU package, not the least from Friday’s G-20 meeting, and we expect several commitments of support from key potential investors, like China, Brazil, mid-east, and other sovereign wealth funds; Japan has already signaled willingness to invest.
We’ll be watching the reaction of risk assets on those expected signs of support, and the less risk markets respond favorably, the greater our doubts about the sustainability of the rebound will grow. We will be especially alert to how markets trade to start the week after a weekend spent digesting the full implications of what the EU has actually delivered.