Euro Rallies on “ESM as Bank” Hopes

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Market Drivers July 25th, 2012
UK GDP shocks shrinking -0.7% vs. -0.2% eyed
IFO weaker but euro ignores as prospect of ESM as bank props market
Nikkei -1.144% Europe up 0.79%
Oil at $88.50/bbl
Gold at $1592/oz (apologies for typo yesterday)

Europe and Asia:
AUD CPI 0.5% vs. 0.6%
AUD Conference Board Leading Index 0.4% vs. -1.3%
JPY Merchandise Trade Balance Total 0.30T vs. 0-.39T
NZD Trade Balance 331M vs. 77M
EUR German IFO Business Climate/Current Assessment/Expectations 103.3 vs. 104.8
GBP GDP -0.7%vs. -0.2%

North America:
USD New Home Sales 10:00

A topsy turvy night in FX as economic data missed its mark, but risk currencies rallied nevertheless on short covering on speculation that ESM would get a banking license, allowing the fund much greater flexibility to act as backstop for EZ credit markets. In UK the last Q2 GDP shocked to the downside printing at a woeful -0.7% versus -0.2% eyed, as bad weather and Queens jubilee depressed economic activity far more severely than markets forecast.

Although the headline numbers are preliminary and may be exaggerated by one-off factors they nevertheless indicate that UK economy continues to suffer its worst double dip recession in 50 years. Total economic output remains 4.5% below the 2008 levels and slightly below the level of 2010 when the new government took office. However, despite the very weak performance in GDP figures highlighted by a massive drop off in construction, many analysts have pointed to a divergence in the official figures as both employment data and tax receipts have shown improvement.

The sense of doubt about the true state of the UK economy moderated some of the decline in GBPUSD with the pair sliding below the 1.5500 level but finding support in .15480 area in mid-morning London trade. The latest GDO figures will no doubt prompt further speculation of additional QE from BOE and GILTS were reflecting that fact as yields declined further. Cable is likely to remain wounded for the rest of the day and could underperform against the euro specifically as some of the safe haven bid leaves the unit.

The euro meanwhile rose in morning session trade despite weaker than expected IFO readings. IFO printed at 103.3 versus 104.8 forecast, but given the very weak PMI data yesterday market were prepared for a poor reading. IFO economist Wohlrable stated that the institute forecasts growth of 0.1% in Q2 and Q3 with retail demand a particular bright spot as private consumption has not yet been hit by the credit crisis.

Currency trader however were much more interested in the comments of Ewald Nowotny who stated during a Bloomberg TV interview that, “I think there are pro arguments for a banking license for ESM.” A banking license would allow the ESM to leverage its balance sheet and give the fund far greater ability to act in the EZ credit markets amplifying its power as backstop for EU member sovereign bonds. The news sparked a short covering rally in the euro pushing it above the 1.2100 level by midmorning European trade.

As we’ve noted yesterday the pair is grossly oversold and due for some upside relief, with today’s speculation on ESM possibly serving as catalyst for further short covering as the day progresses. The North American calendar is light and much of the action in FX will depend on whether stocks can hold bid despite disappointing earning from Apple last night. If equities do manage a rally and risk appetite improves, EURUSD could move towards the 1.2200 figure as short covering accelerates during the North American day.

Boris Schlossberg
Managing Director

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