Over the past several weeks the EUR/USD has defied its most ardent critics as it rallied more than 500 points off its recent swing lows as fear of fracture have eased. Much to the consternation of the shorts which bet that the break of the European Monetary Union was imminent, the opposite occurred. Spreads in the periphery sovereign debt credits has eased markedly. The new set of auctions Spain and Italy saw yields drop by 100-200 basis points lower from the period prior, with Spanish 3 month T-Bills going off at below the 1.00% mark. The bid to cover ratios also improved indicating that investors are more confident in the credit quality of Club Med economies.
The improvement in the European bond markets was largely due to a concerted communication campaign by the regions fiscal and monetary authorities that reaffirmed the commitment to the euro and offered unequivocal support for the single currency. Both German Chancellor Merkel and ECB President Mario Draghi made strong statements in support of the euro and so far the jawboning campaign has been highly successful, rallying the single currency and stabilizing the credit markets.
However, this rally has been driven by nothing more than rhetoric as authorities in the region have yet to put forth concrete policy proposals that will ensure the stability of the single currency. As market participants return from their summer vacations, the focus will shift squarely from words to deeds, with traders eager to see specific measures that would ensure the viability of the euro for the long term. The fact of the matter is that despite the mild improvement in periphery yields, the spreads between the core and the periphery remain unsustainably high leaving both Spain and Italy with very difficult debt service burden for the foreseeable future. Analysts are almost in universal agreement that in order for the euro to survive the EZ will need to move to a mutualization of sovereign debt and consolidation of national budgets.
Yet Germany has been reluctant to move towards such a policy solution. As EZ biggest and strongest economy, Germany is the key to the success or failure of the single currency, yet support for the euro amongst its citizenry has been tepid at best. The irony of the matter, is that Germany has benefited disproportionately from a unified currency regime. As Europe leading exporter it has enjoyed price stability and price uniformity that have allowed its economy to thrive even as it neighbors down south have suffered.
However, as we move into the fall season, German economy is showing clear signs of stress, the latest data on unemployment, retail sales and flash PMI readings all point to a marked slowdown in economic activity. The economic news shows that Germany is not immune from the malaise that gripped the rest of the continent. The key question going forward is whether this economic slowdown will make German populace more or less amenable to further integration. Ms. Merkel has made concerted efforts to move Europe towards more structural cooperation, calling for a European convention to create the proper institution for further fiscal integration, but she faces stiff opposition at home. If Germanâ€™s decide to turn inward believing that their economic fortunes will be better off without the euro than with it, her efforts to lay a fiscal foundation under the single currency will likely fail and the euro will come under renewed selling pressure.