EU Summit Makes Progress, EU Debt Crisis Has Not

This is the last formal North American Daily for the 2010. We will release a shortened holiday mode for the next two weeks and will return to full publication 01/03/2011. Happy New Year!


The US dollar is trading on an easier footing as the market remains sensitive to US Treasury yields. European currencies are mostly up versus the dollar as EU leaders agreed on a permanent rescue mechanism at the EU summit. The euro was also supported by strong economic data, despite Ireland’s downgrade by Moody’s, as Germany’s December Ifo index hit a record high and French business confidence surprised to the upside. The euro, coming off records lows, continues to rally versus the Swiss franc and the Scandinavian currencies. Meanwhile, cable underperformance was persistent and price action choppy following the weak UK Nationwide consumer confidence data and the latest BoE Financial Stability Report. The report, in effect, highlighted the risk of future bank write-offs. The dollar remained stable just around ¥84.00, after trading into ¥83.70 due to a softer dollar tone. Elsewhere, the dollar is up versus the dollar bloc as the combination of profit taking and yield advantage helped support the dollar in light trading.

Global equity markets are quite subdued, trading moderately lower following a strong North American session. The MSCI Asia Pacific index, however, is up with a 0.3% gain. Finance and real estate shares in Japan led the performance in the Nikkei after the BoJ bought REITS for the first time, following some front-running in that sector. Meanwhile Chinese stocks continued to decline with the Shanghai index down 0.1%. On the whole, European bourses are down again, torn between positive data yet continued weakness in the periphery, with the Euro Stoxx 600 down 0.3%. The benchmark index was buoyed by technology but dragged down by health care. At the same time, the FTSE is down and the Dax is flat with the FTSE led by losses in health care following the weak consumer confidence numbers.

Ireland’s debt rating was downgraded five notches by Moody’s to Baa1 from Aa2 with the outlook on the rating negative, suggesting further downgrades may be in the works. As expected, this news weighed on the peripheral bond market with Ireland’s 10-year yield up 13bp. Overall, the average yield of the 10-year periphery debt rose to 8.06% which is now 500bp over the relatively safe German 10-year. The periphery spread to Germany has moderated since the all-time high of 575bp in early December but risk premium on periphery bonds remain elevated, which only exacerbates the fiscal issues as higher funding costs lead to higher deficits. Meanwhile, UK government bonds rose, paring their third weekly decline, after Ireland’s credit was downgraded, which drove the 10-year gilt down 8bp. Equally important, German bunds gained with the 10-year yield falling 4bp while JGBs rose amid speculation that the BoJ will continue with monetary easing.

Currency Markets

The EU Summit may have ended, but the European debt crisis has most certainly not. What does it really matter to current investors, under mark-to-market pressure that the European officials have agreed to some wording changes in their Treaty to allow for a permanent crisis facility at the end of 2013? Even the aid packages for Greece and Ireland have not stabilized their situations as Moody’s 5-notch cut in Ireland’s debt rating to Baa1 and a negative outlook today illustrates. Recently Moody’s also put Greece (and Spain) on credit watch for a possible downgrade. European officials do not appear to have taken any fresh initiatives to address the current pressures. It is disappointing and there is a price to pay for that disappointment. In the first instance the high debtors in the union will pay higher yields and all the ramifications in terms of debt serving costs and growth retardant. It also would seem to increase the likelihood that investors judge Portugal as ill-positioned to stand alone. While the data is far from transparent, it appears that Portugal has about €11bln of maturing sovereign debt in Q1 11.

The ECB’s efforts may be helping to keep rates from rising too much, but there is limits on its ability as rise in Irish and Greek bond yields indicate. Other euro zone countries, including Spain, Italy and Belgium have relatively large sums to fund in Q1 11 as well. In about a month’s time, a newer bond issuer will appear on the stage. Reports indicate that the EFSF is preparing a €5bln offering in the second half of next month. More immediately, on Monday the market will learn the size of the ECB’s recent bond purchases. The market has been generally disappointed with the size of the recent bond purchases even though they increased from a low base, but impressed the impact. Next Wednesday, the ECB will offer an unlimited amount of 3-month money. This could catch some market participants who don’t follow the minutia, unaware because the next day there are around €200bln or repos expiring, including the last of the 12-month funds. Interpolating from prices in the forward market, there is increasing concern about dollar liquidity, where non-US banks are swapping euros for dollars.

Consumer confidence fell to a 20-month low in November, according to the Nationwide, almost completely reversing the rally in sentiment that took place from mid-2009. The index of sentiment fell by 7 points to 45, the lowest since March 2009, reflecting concerns about government cuts. The measure of expectations fell 9 points to 61, also a 20-month low. Another negative is the fact that average pay hasn’t kept up with inflation, suggesting further declines in spending. This is important for the inflation debate since the BoE is watching the stickiness of retail and wage inflation, which is more important to overall costs than imports. The BoE is less worried about imported inflation as they feel the effects are temporary. Meanwhile, the UK’s big four banks have up £80bln of bad consumer debts on their books that weren’t anticipated, according to the BoE’s FSR. Thus, an impairment that will be a further drain on bank’s profits, which could weigh on sterling. As we have highlighted before, sterling has a strong correlation with the UK banking sector since bank’s revenue account for a large share of tax revenue. The BoE warned that in the extreme case, which it defines as being if write-offs reached similar levels seen in the early 1990s recession, the impairment would account for 28% of the lenders’ £281bln total tier one capital.

Upcoming Economic Releases

At 10:00 EST / 15:00 GMT the US releases November’s leading indicator which are expected to increase to 1.1% from 0.5% in October. Events: Colombia’s overnight lending rate decision which is expected to remain unchanged at 3%.

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