Will the EU Summit Crush the Euro?

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Daily FX Market Roundup / Asia Preview 06-27-12

Will the EU Summit Crush the Euro?
USD: Benefitting from Stronger Data
GBP: Hit by Sharp Pullback in Borrowing
NZD: Trade Surplus Narrows on Strong Rise in Imports
CAD: Higher House Prices
AUD: Hope for the Commodity Sector
JPY: Danger of Consumption Tax

Will the EU Summit Crush the Euro?

In less than 24 hours, European Leaders will be gathering in Brussels to decide the future of the euro. By now, everyone knows that the Germans staunchly oppose any type of liability sharing and the chance of changing their minds over the next 2 days is practically zero. This week German Chancellor Merkel took every opportunity to reject the notion of Eurobonds or any type of liability sharing including joint deposit insurance. Not only did she make her stance abundantly clear but to remove further ambiguity Merkel went on to say that she doesn’t see it happening in her lifetime. In light of this very public opposition to sharing sovereign credit risk, it would be safe to assume that most investors expect the EU Summit to be a big disappointment. In fact very few EU Summits have resulted in major announcements because these meetings are driven more by politics than economics. For this reason, a compromise from the Germans and a credible blueprint for a fiscal union could trigger a larger reaction in the euro than the disappointment.

To be clear, we still expect the euro to weaken if EU leaders fail to convince investors that progress is being made, but disappointing results may not be enough to drive the EUR/USD to a fresh 2 year low below 1.2288. This is because investors will quickly shift their hope over to next week’s European Central Bank meeting. If the EU Summit doesn’t go well and the markets react negatively to the outcome, everyone will look for the ECB to play the role of the white knight riding into the rescue. Now if the ECB fails to provide any fresh support, the EUR/USD will then collapse more significantly as investors finally realize the gravity of the situation and the impossibility of recovery without an agreement from the Germans. What Europe needs and what EU leaders will deliver are two completely differently issues. We know Europe needs Eurobonds and Guaranteed Deposit Insurance to prevent defaults and bank runs, but the contentious debate around these issues means that all we can expect from EU leaders are the following:

What EU Leaders Will Deliver

– EUR130 billion Growth Package
– Tax on Financial Transactions
– Single European Banking Supervisor

We know there will be at least 2 major announcements on Friday – a EUR130 billion growth package and a financial tax that would be used to pay for future bailouts. Both of these measures were agreed to at the four-way summit between German, French, Italian and Spanish leaders last week. While sovereign credit risk is important, supporting growth is also a critical step to turning Europe around because at the end of the day, the real problem in all of these countries is the high level of unemployment. Details on what the growth package will include should be shared this week along with the announcement of a Tobin tax, which is tax on financial transactions (sale of stocks, bonds and derivatives) that help to raise money for the governments and for future bailouts. There should also be plans to form a single European banking supervisor that oversees the region’s biggest banks. All these proposals are quick wins that can be implemented quickly without a change to the EU Treaty. Unfortunately none of these are the solutions that Europe really needs to end its debt crisis.

USD: Benefitting from Stronger Data

The U.S. dollar traded higher against all of the major currencies with the exception of the Australian and New Zealand dollars. Stronger U.S. economic data fueled the gains in the greenback and the rise in equities. Durable goods orders in the U.S. rose 1.1 percent last month on higher defense and nondefense aircraft orders. This increase was larger than expected but excluding transportation, durable goods orders rose by only 0.4 percent. Orders for products made to last more than a few years can be volatile and is usually not a big market mover for currencies but after 2 months of negative durable goods orders, today’s report will contribute positively to growth. Pending home sales also rose 5.9 percent after falling 5.5 percent the previous month. Not only did the rebound erase all of the past month’s weakness but it was also the strongest gain in 12 months. While the data is encouraging, there is still not enough improvement to make the Fed less likely to increase stimulus. The monetary policy plans of the Federal Reserve and many other central banks largely depend on the risk premium in the market and developments in Europe. Over the next 24 hours, the only thing that matters to the dollar is the amount of risk aversion created by the EU Summit – risk on / risk off will determine the direction of the greenback. The final release of first quarter GDP is tomorrow along with the weekly jobless claims report. No major changes are expected, leaving Europe as the market’s number one focus.

GBP: Hit by Sharp Pullback in Borrowing

Despite mixed economic data, the British pound sold off against all of the major currencies. Evidence of stronger consumer spending was offset by the first ever decline in home loans. For the past 15 years, the British Banking Authority has kept track of the amount of loans for house purchases on a monthly basis and for the first time ever, the amount of mortgage debt paid exceeded the amount borrowed. This tells us that Britons are actively trying to reduce their debt levels, which is important because it reflects caution and nervousness among U.K. homeowners. The economy is in recession and recent economic indicators show very little sign of improvement. According to the Confederation of British Industry, retail sales rose strongly in the month of June but the data is distorted by the additional holidays and the Queen’s Diamond Jubilee. What we do know is that the U.K. economy is performing poor enough that a large number of policymakers are calling for more easing. Nationwide house prices are due for release tomorrow along with the final first quarter GDP numbers and current account balance.

NZD: Trade Surplus Narrows on Strong Rise in Imports

The Australian and New Zealand dollars continued to edge higher against the greenback as the Canadian dollar steadied. No economic data was released from Australia but a report from the Bureau of Resources and Energy Economics that saw an 8 percent hike in energy and mineral export earnings this fiscal year helped to lift the currencies. While slower growth in China is a threat to Australian commodity demand, BREE notes that Australia should continue to its role as a catalyst for the world economy. Home sales and job vacancy numbers are due for release this evening – neither of which will marketing moving for the AUD. New Zealand’s trade balance on the other hand narrowed in the month of May with imports growing at a faster pace than exports. Lower commodity produces reduced the value of goods sold by New Zealand abroad while higher demand for crude oil and gasoline boosted imports. The New Zealand government announced that Graeme Wheeler will replace Alan Bollard’s as central bank governor at the end of his term. With the change of leaders could come a change in interest rates, which has been frozen since March 2011. Wheeler has experience in monitoring domestic and international economies and should serve as a formidable replacement for Bollard. Meanwhile despite the decline in the loonie, house prices in Canada grew at a faster pace last month.

JPY: Danger of Consumption Tax

The Japanese Yen weakened against all of the major currencies except for the British pound. Prime Minister Yoshihiko Noda successful passed his bill to raise the consumption tax through the lower house, however at the cost of weaning off one-fifth of his party’s lower house lawmakers. With 57 lawmakers voting no and Democratic Party of Japan’s leader Ichiro Ozawa considering leaving and forming a new party, it will be hard for Noda to maintain a majority vote. Ozawa noted that he would attempt a final effort to collate with the DPJ. Noda has his political career at stake here to try to get this bill supported by the upper house but it will pass regardless because it has support from the LDP and New Komeito party. In 1997 when the then Prime Minister, Ryutaro Hashimoto proposed a similar scenario, it drove the economy into a 20-month recession and cost him his job. In January the Japanese government reported that the planned tax increase would lead to inflation rising between 3.1% and 3.8% by 2014, in comparison to 0.7% and 1.4% without the tax hike. In the long run however, the focus on reducing debt levels comes at the expense of growth. It will be a busy night for Japan with manufacturing PMI and retail trade scheduled for release..

Kathy Lien
Managing Director

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