EURO Weight on Germany too heavy?

The market has already been forewarned that there will be no political end to the Euro-zone crisis from today’s tete-a-tete between Merkel and Sarkozy. Even with German officials insisting that Eurobonds were not on the agenda, a reluctant Chancellor may have to accept that there is only one way to prevent the Euro collapse and that is with Eurobonds replacing sovereign bonds. This would require members to pool their Eurozone risk to reduce their refinancing costs. This is good for struggling members like Greece and Italy. However, the borrowing costs would also rise for the Germans and the Dutch, maybe costing them their triple-A rating.

Issuing Eurobonds, it is believed would add EUR47b to the Germans bill, a snip if you look at the alternative. Capital markets successfully attacking Italy, then France, the Germans losing their coveted AAA credit rating. This in turn could trigger a global depression and a bill for the Germans three times the cost of issuing Eurobonds. As a politician, Merkel must keep her options open!

This morning, the EUR remains supported by a combination of the short selling ban and growing concerns about outflows from a ‘be-leagued dollar’. The divergence in growth between the core and periphery countries is narrowing as noted from the disappointing German GDP data. Growth in Europe’s largest economy slowed sharply in the second quarter (+0.1%), leaving it below pre-crisis levels and calling into question Trichet’s decision to tighten twice this year. Combined with the French data last week, this is more than just a soft patch for the ‘invincible core’. Perhaps policy makers may have to begin their discussions on reversing this years hikes over the coming months?

The US$ is stronger in the O/N trading session. Currently, it is higher against 12 of the 16 most actively traded currencies in a ‘whippy’ session.

The ECB came off the sidelines, for the first time in nineteen weeks, to shore up market confidence and announced yesterday that they had settled EUR22b in bond sales last week, the highest weekly settlement in thirteen-months since it began buying Euro-zone government bonds in the secondary market. Since it takes a few days for bond transactions to settle, analysts believe that the final monetary intervention value will be close to EUR25-30b. As a term of reference, just after the first Greek bailout package, the ECB bought +16.5b in bonds. It is believed that the bulk of the buying was that of Italian and Spanish bonds. Their direct intervention has helped lower significantly the cost of borrowing for both sovereign entities. To date, the total acquisition under the ECB bond buying program equates to EUR96b. Given the size of the Italian and Spanish bond market, the sum is not particularly high, but it seems to be sufficient to show capital markets that the ECB is serious about containing the sovereign debt crisis.

Yesterday’s US June TIC’s data is notable for a record foreign private sector selling of bonds, notes (-$18.3b) and long-term securities ($23b) compared with the previous record set during the height of the financial crisis in 2008. The increased sales had been influenced by the debt-limit deadline. The market should be prepared to see a further negative overhang in July’s data, as a resolution did not occur until the beginning of this month. The ‘net’ underlying long-term securities transactions (ex-swaps) in June was a positive +$3.7b and down from a weak +$24.2b print in May.

The dollar is higher against the EUR -0.44%, GBP -0.20% and lower against CHF +0.34% and JPY +0.02%. The commodity currencies are weaker this morning, CAD -0.64% and AUD -0.82%.

Over the past three trading sessions, the loonie has managed to advance from almost its lowest level in seven-months as equities stateside rise, reducing the demand for the buck as a refuge. The CAD, despite last week’s turmoil remains one of the better behaved currencies, even with weaker domestic data. Late last week, Canada recorded its biggest trade deficit in nine-months in June (-$1.56b the fifth consecutive), as energy and auto exports fell, adding to evidence the country’s recovery is waning. Governor Carney said last month that export growth will remain modest because of a strong currency and the need for companies to regain competitiveness.

This month, the loonie has dropped -3.1% as global equities tumbled on renewed concern that the Euro-zone’s sovereign-debt crisis is getting worse. The CAD, seen as a barometer of risk, closely tracks oil, equities and macroeconomic data from the US, which consumers about +70% of all the country’s exports. Yesterday’s disappointing Empire State Manufacturing Index had the loonie underperforming against the other major crosses because of the depth of its economic ties with its largest trading partner.

There is a flip-side, because of the yield differential (for now), investors will want to divest away from the EUR and USD. Once the markets absorbs all of last weeks Cbanks actions or lack of, there will be an appetite from investors to own a second tier reserve basket. Most commodity and interest rate sensitive currencies certainly belong to this basket. The focus this week is likely to remain on broader risk aversion, however, there may be a shift back to fundamentals as investor sentiment starts the week on a calmer footing.

Uncertainty around Eurozone’s austerity measures and debt management issues along with overall global growth forecasts will have investors treading lightly. In the O/N market, investors have been better buyers of dollars on pullbacks (0.9835).

The AUD traded under pressure against all its major trading partners last night, after the release of the Cbank’s August minutes which showed policy makers are concerned that turmoil in financial markets could slow global economic growth. It was the first day in four that the currency retreated outright, as investors pared bets of an interest rate hike any time soon.

The RBA’s August minutes were largely in line with the post-policy meeting statement, however, concerns over developments in Europe and the US continue to overshadowed the RBA’s robust medium term domestic outlook. Many now expect Governor Stevens to remain on hold for the remainder of the year, as ‘risks for the RBA have become more evenly balanced and the outlook remains conditional on the strength of the global economy’. If global turmoil continues, it could temper domestic inflation over time and ease pressure on the RBA to raise interest rates. Some futures traders now expect the RBA to reduce its key interest rate by-128bp over the next 12-months. Even with core inflation still running above the RBA’s target range, the policy makers can afford to step aside, unless there a dramatic collapse in global financial markets. That can be said for all other Cbanks. Just like the loonie, the AUD will trade with the swings in global risk appetite. Currently, investors are better sellers of the currency on rallies (1.0438).

Crude is lower in the O/N session ($86.71 down -$1.17c). Crude prices rallied for a third consecutive day yesterday, rebounding from last weeks ten-month low, after M&A activity dragged US bourses higher and on Japanese’s data contracting less than expected in the second quarter at the weekend. This morning’s disappointing European data is providing the excuse for energy prices to take a step back.

Last week’s US inventory numbers had been been bullish for the commodity. The report showed that oil stocks fell -5.2m barrels to +349.7m last week. The market had projected a +1.5m barrel build. Crude imports fell-34k barrels per day to +9.07m. The IEA stated that the US’s SPR saw its stock levels fall -2.5m. Not to be outdone, gas stocks dropped -1.59m barrels to +213.5m, compared with market projections for a +500k barrel build. Average gas demand over the last four-week’s has fallen-3.4%, y/y. Distillates (heating oil and diesel) fell-737k barrels to +151.5m versus an expected rise +1.1m barrels. Refinery utilization increased +0.7% point to +90% of capacity, whereas the market projected a decrease of -0.4%

Crude prices continue to hold just above strong support levels. The Fed’s monetary policy will be bearish for the dollar and so should be bullish for crude in the longer term.

Ever since the CME changed the margin requirements for gold (+22%), the weaker bulls have had their backs against the wall with prices plummeting. Yesterday, the commodity gained for the first time in three sessions as a weaker dollar revived demand for the metal as an alternative investment. Apart from the administration side effects of owning the commodity, the metal continues to be a recipient of safe-haven flows. This morning’s weaker than expected German GDP print is again providing support. Gold’s prices have more than doubled since the recession began in late 2007. The metals climb has accelerated on the back of the European debt crisis threatening to spread to three of its biggest economies, France, Spain and Italy. The Fed’s efforts to drive interest rates lower to support lending are curtailing the dollar’s appeal as a safe haven and by default, support commodities.

Investors have bought more gold in the last month than in the prior six months according to CFTC data last week. The commodity is heading for its eleventh consecutive annual gain. In this trading environment, $2,000 is very much in the realms of possibility over the next six months ($1,779 +$21.20).

The Nikkei closed at 9,107 up+21. The DAX index in Europe was at 5,877 down-145; the FTSE (UK) currently is 5,272 down-78. The early call for the open of key US indices is lower. The US 10-year eased 1bp yesterday (2.26%) and is little changed in the O/N session.

Treasury prices were little changed along most of the yield curve Monday, apart from long-bonds, who happened to have a lousy 30-year auction last week, as global equities found some of their lost ‘mojo’. Investors are looking for any signs of stability after last weeks hyped up volatility sent them scurrying to the exits demanding safe heaven product.

With the short end of the yield curve resigned to trading on top of o/n fed funds, dealers will expect longer-dated product to trade more volatile as investors reach for yield and on speculation that the Fed may extend bond buying away from shorter-dated notes and towards 10-year notes to help stimulate the economy. Month-to-date, treasuries prices have surged, pushing 10-year yields down more than-50bp. For the near term, bond investors are likely to continue to keep a close eye on equities as they dictate Treasuries’ moves.

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