Can EZ Policymakers Get it Together?

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Market Drivers August 20th, 2012
Talk of ECB capping spreads in periphery yields helps lift EURUSD
Aussie firmer as risk sentiment improves
Nikkei up 0.77% Europe up 0.66%
Oil at $96.01/oz.
Gold at $1619/oz.

Europe and Asia:
NZD Performance Services Index 53.1 vs. 53.9
JPY Leading Index 93.2 vs. 93.6
EUR Eurozone Construction Output -0.5% on the month
GBP Rightmove House Prices -2.4% vs. -1.7%

North America:

It been a very quiet start to the week’s trade highlighted by the near absence of any economic data as currency markets remains in state of suspended animation ahead of what promises to be a flurry of activity in September as EZ officials continue to battle with the sovereign debt crisis in the region. Over the weekend an article in German magazine Der Speigel suggested that ECB officials may be considering a plan to cap interest rate spreads in the EZ credit markets.

According to the article the ECB would set an explicit top yield threshold for various periphery bonds. For example it may state that it would not tolerate a spread of greater than 300 basis points for 2 year Italian bonds versus German bonds of same maturity and would enter into the market to stabilize the relationship. While such strategy is always vulnerable to the risk of moral hazard, many analysts believe that the mere act of jawboning could neutralize most of the market specs requiring very little capital from the ECB to put the policy in place. As template the market is looking to the SNB action on the EURCHF exchange rate which has held steady at 1.2000 for nearly year as a result of complete central bank commitment to those levels.

Some analysts however remain skeptical that the ECB and more importantly German fiscal officials would agree to such a plan, effectively making the central bank the lender of last resort in the region. The ECB itself has issued a terse “no comment” on the matter which sounds like a non-denial denial from the monetary policy makers in Frankfurt.

The macro issue will likely come to a head this Thursday when Angel Merkel and Francois Hollande meet to discuss possible strategies for stabilizing yields in the region. We believe that both officials understand the gravity of the situation as well as the risk of doing nothing. The stress on the periphery yields is the single most pressing economic issue in the region as it greatly hampers the ability of sovereigns to operate their budgets and in turn exacerbates the economic slowdown across the whole EZ. Conversely a sharp decline in Spanish and Italian yields would provide instantaneous relief by easing the debt service costs for those economies providing a boost to credit and stimulus.

The EUR/USD has been stymied several times at its attempt to clear the 1.2400 barrier as the pair tries to stage a recovery rally. This Thursday’s combination of macro and micro events could prove pivotal to the pair’s near term direction. If investors perceive a sense of true commitment on the part of Merkel and Hollande to stabilize the periphery sovereign debt markets while the eco data shows no further deterioration in demand, the news could propel the euro through that key resistance level and perhaps through the 1.2500 barrie as well. If on the other hand EZ policy makers continue to dither, the sense of disappointment in the market could embolden the shorts to gun for the 1.2000 barrier once again.

Boris Schlossberg
Managing Director

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