Buy Euro Rumor; Sell Hard Fact, Tact Worth Preserving?

by: Dean Popplewell

If the euro story were confined to Germany, the shared 17-member currency unit would be a keeper. However, German services PMI is only "a ray of sunlight amidst the gloom." Euro economic data this morning initially helped to underpin sentiment and gave the EUR a boost outright. Despite strength at the euro-core being formidable, the core is but one member and not a team.

The full barrage of eurozone PMI released earlier was not too far off expectations. If anything, the French data came in better than expected, with the service sector report up to 43.7 versus expectations of an unchanged final reading (42.7). The German data is also stronger than expected, where the services PMI bounced to 54.7. The official gap between the eurozone’s two largest economies - Germany and France - is officially now at its record widest and reflects the dramatic difference between the two economies. For Italy and Spain, the eurozone's two other major economies, the services PMI were 43.6 and 44.7 respectively. This seems to be par for the course for the peripherals, and if anything, a better showing given the uncertain Italian political situation and its effect on their domestic economy.

The region's aggregate numbers came in a little higher than expected, with both services and the composite data moving a tad higher to 47.9 from last month’s unchanged final reading of 47.3. The bump mostly reflects the uptick from the eurozone's two major economies. The pleasant surprise has bunds trading close to their lows and the peripheral spreads trading much tighter. Does it have the momentum to support risk-on or will it be a rally killjoy?

Rate decisions by central banks will get to dominate most of the remaining market rhetoric this week. The ECB certainly remains on tender hooks with about 30% of futures dealers pricing in a refi-rate cut on Thursday. With Europe’s third largest economy, Italy, struggling to form a government and being exposed to higher funding rates, it certainly supports the ECB’s rate doves in the short term. However, clear concise ECB rhetoric can be just as effective, easily preparing money markets for a rate change rather than the action itself. Euro policy makers make it a habit of not been too directly adventurous; there are too many members to appease.

With Italian debt and equity markets trading overall heavy, the rating agencies are being watched carefully as an imminent downgrade rumor swirls in the Twitter-sphere. The lack of a clear path towards the formation of a government and anti-austerity vote remains a threat to the eurozone and the 17-member single currency. Tough odds for forming a government should increase political risk. Even the ESM, a permanent firewall for the eurozone, is now seen an unlikely tool to be used this year as the Germans push back. This leaves the ECB’s Outright Monetary Transactions (activity in the secondary and sovereign bond market), but the “terms of conditionality” requires an Italian government agreement and with none forthcoming only exposes the EUR to further outside threats.

The “Old Lady” has a close call this Thursday. Consensus is probably swaying towards the Bank of England to keep policy unchanged after an increase in new business helped lift the U.K.’s service sector PMI to a five-month high last month (51.8). The morning’s print suggests that the British economy may “eke some growth in Q1 of this year.” The faster growth of the dominant service sector is happening to offset the manufacturing and construction shortcoming reported last week. Last month's MPC minutes showed that three-members voted for an extension of QE by +£25b. This has allowed sterling to bounce from its 32-month lows and into more desirable levels if one wanted to short the market.

Today, Latvia is set to officially apply to join the euro next year. The country has effectively been on the euro entry path for nearly a decade now, having joined the EU in 2004 and pegged its currency, the “lats,” to the EUR the following year. The diminutive country now meets the key criteria for membership. Its budget deficit for this year is forecasted to be at +1.1%, its government debt stands at +41% of GDP and last year inflation number stood at +2%. By all accounts it looks like a model member to be held in high esteem ahead of the euro-periphery nations. The country is coming through a harsh recession and continues to grow strongly after +5.5% growth last year.

Why should they take the plunge? Latvian banks will gain access to ECB’s liquidity facilities and could use it as a backstop in a liquidity crunch. Becoming a member should cut the country’s borrowing costs, improve its credit standing, reduce transaction costs and promote outside investment due to an increased confidence perception. From an economic perspective, it opens up the trade routes with Western Europe. Latvia only needs to look toward Estonia to see how its export industry benefited since joining the euro in 2009. Around 56% of the Latvian population is against joining the euro, as Latvians will have to pay their share of any future euro bailout. However this negative seems to be outweighed by all the aforementioned pluses.

Today in the U.S., the market is perhaps looking for a slightly lower reading on the U.S. ISM Non-Manufacturing Index for February, expecting a drop to 55 from January’s 55.2. If true, and despite being the lowest level in three-months, it would still suggest continuing economic expansion, and would support a yield move to break higher upon removal of some of the fiscal uncertainty. This could translate into improved risk appetite, especially for growth proxy currencies like the CAD and MXN. However, with central bank decisions in both countries, investors should remain somewhat reserved in formulating a deeper commitment until all central bank rate announcements are known.

So far, the single unit is having a "buy rumor sell fact" kind of day. Ahead of the euro data this morning, the market had been steadily bid with dealers looking for easy weak stops topside. Those stops immediately became vulnerable when eurozone’s PMI eased above expectations. Once triggered, real money selling has dominated with a splatter of hedge funds now preparing to sift out the weaker long positions accumulated on the way up. All the strength of the euro PMI’s was at the core, the rest was a dismal read and reason enough to want to sell EUR’s short on rallies.

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