One of the most important lessons we learned this week is that nothing but a tighter fiscal and monetary union can end Europe's sovereign debt crisis and restore confidence. We started the week with the best possible outcome in the Greek elections. The pro-austerity, pro-euro party won, eliminating the near term risk of a Grexit. The euro rallied in response, but its gains were short-lived as the market shifted its focus to Spain. Solid demand for Spanish bonds in this week's auctions eased anxiety in the market and reduced the risk of a full sovereign bailout but even then, the EUR/USD struggled to rally. Today, the European Central Bank eased collateral requirements, allowing banks to post loans rated BBB- or higher instead of A- or higher. The goal is to put more money into the hands of banks who were running out of collateral rated higher than A-. By easing collateral rules, the ECB provided relief to the market but like the Greek elections, the rally in the EUR/USD was short-lived. This time around, it was because the Bundesbank said it won't accept the collateral unless they have to. Not too long after, the leaders of the four largest economies in the Eurozone also announced a EUR130 billion growth package that they will try to rally support for over the next week. At 1 percent of GDP, this sizeable amount of support helped to stabilize the euro but the rally that followed was modest at best.
Only a fiscal and monetary union can end the region's crisis but this would require Germany lending its AAA credit rating to the rest of the region and accepting the consequences that follow such the risk of assuming liabilities of defaulted nations and higher interest rates. Traders were unimpressed by these initiatives because German Chancellor Merkel did not soften her stance on a more flexible use of the existing bailout mechanism. She continues to resist key changes such as joint debt issuance, which would bring down the borrowing costs of weaker Eurozone nations and raise the borrowing cost for Germany. She refuses to lend Eurozone bailout funds directly to banks and doesn't support ECB purchases of sovereign bonds. Most importantly, she opposes a European guarantee deposit system, which would prevent a run on banks. What the leaders of Germany, France, Italy and Spain did agree on was a financial tax that would be used to pay for future bailouts but judging from the price action of the euro, investors were not impressed. Merkel is outnumbered but she holds the purse strings and getting her concede will be difficult. It is against this backdrop that we enter the new trading week where the number one focus will be the EU Leaders Summit. Hopefully all of these preparatory meetings will result in real progress and not further delays.
USD: Next Week's Data Should Reinforce Need for QE3
The U.S. dollar traded lower against all of the major currencies with the exception of the British pound, which was held back by this week's softer economic reports and the prospect of more stimulus from the Bank of England. The main take away from this week's U.S. economic reports, FOMC meeting and comments from the Federal Reserve is that the Fed is prepared to ease. Weaker economic data hardened the case for QE3 as the cracks in the manufacturing sector, housing and labor markets become more evident. While the dollar ended the week higher against most of the major currencies, the need to adjust QE3 expectations should cap near term gains in the greenback. The extension of Operation Twist should be the first step to easier monetary policy from the Fed. In the coming week, Europe will be the main focus, which means that risk appetite will determine the trend of the dollar. With that in mind, there are a few pieces of U.S. data worth watching including new home sales, consumer confidence, durable goods orders, pending home sales, revisions to first quarter GDP, personal income, personal spending and Chicago PMI. Given this week's economic reports, the decline in confidence reported by the University Michigan consumer sentiment survey and the decline in retail sales, we expect these reports to be negative for the dollar by reinforcing the need for QE3.