Will a Delayed Fear of Collapse Allow for a Recovery?

Fundamental Forecast for Euro is Neutral (overall, no significant price action). Greece receives its first tranche of support on the same day Germany announces a naked short-sale ban. Germany passes its bailout obligations, Spain and Portugal cut spending. Has EURUSD marked the turning point in its 6-month bear trend, or is this just a pause?

Next week, German Chancellor Angela Merkel will present a nine-point plan to a European Union working group that includes plans to withhold funds and temporarily withdraw voting rights from countries that ignore union rules on debt levels. The plan is also expected to include new rules to allow bankrupt countries to exit the union in a ”orderly manner”. The plan can easily create more nervousness among market participants and investors in the coming week(s). Despite the recent bold move from ECB, EU and IMF, policy makers in Europe are still struggling to prevent contagion from the European debt crisis. So far they have not been particularly successful with global risk appetite tumbling hurting equities, credit bonds, commodities and high-yielding currencies badly. Danske expect mainly tier two data out of Europe next week. Focus will remain on the ongoing developments in the euro debt crisis. Today the German parliament approved German participation in the EUR720bn European Stabilisation Mechanism (ESM). Danske expect more countries to follow in the coming weeks. Furthermore, They expect to receive more details on how the EUR720bn will be constructed. There are plenty of unknowns in terms of how the special purpose vehicle (SPV) of EUR440bn will be constructed. It remains an open question whether each individual member state will be legally responsible for their share of the guarantee only.

The dominant theme has been the German short-selling ban, which was announced on Tuesday evening and legally implemented on 19 May. The stated motive was to reduce market volatility. However, the measures introduce uncertainty about which activities are prohibited. Furthermore, it adds to the uncertainty over what to expect from authorities in terms of regulation, etc. The directive has increased volatility in the financial markets. Angela Merkel later said that “politicians are no financial experts”, which might be the most astute comment of the week. However, the short-selling ban is likely to be the price for the approval of the EUR720bn aid deal in the German Upper House, which happened toFriday. On the data front, ZEW expectations fell, but this was only expected due to the latest rise in financial volatility. It is however notable that ZEW current conditions continue to improve.

In Germany, inflation fell to 1% in April from 1.2% in March. Higher energy and food prices continued to drive up headline inflation, but core inflation declined to 0.2% from 0.9% in March. This decline is partly due to a calendar effect (the Easter holiday occurred in March this year), which coincided with lower prices for hotels, restaurants and leisure activities. Inflation is likely to rise slightly in May (figure to be released on Thursday, 27 May). Food prices will continue to rise and core inflation should increase slightly. In France, business sentiment in the manufacturing sector improved significantly in March and April with a net rebound in orders books as well as in the general and individual production prospects of business leaders. The Markit PMI survey of purchasing managers in the manufacturing sector confirmed the improvement in activity in recent months. In May, the activity index declined slightly but held at a high level. The INSEE business climate index, which is still below its long-term average, could pick up again in May (figure to be released on Wednesday, 26 May), albeit by less than in previous months. After contracting since the beginning of the year, household spending on manufactured goods rebounded strongly in March (+1.2% m/m), fuelled primarily by the rebound in automobile sales. Given the undoubtedly temporary nature of this stimulus and the current slowdown in household purchasing power, spending probably declined slightly in April (figure to be released on Wednesday, 26 May). This decline would coincide with a slight decline in the INSEE household confidence index in April (down 1 point after shedding 3 points in March). The upturn in inflation, the end of last year’s measures to boost purchasing power and more generally, the prospects of a tighter budget policy should continue to strain household confidence in the future. Under this environment, the index could decline slightly again in May (to be released on Thursday, 27 May).

Germany’s unilateral decision to ban naked short selling of government bonds, CDS and shares of its top 10 financial institutions sent shockwaves through global financial markets, prompting participants to shun risk assets and currencies in favour of the USD, JPY and government bonds. The AUD dropped like a stone vs all G10 currencies, shedding a staggering 13% vs the JPY and 9% vs the USD. GBP/AUD rallied over 6%, taking out key resistance in the 1.70 area. The moves are collateral damage from the risk aversion trades that are stalking the EUR. Efforts by EU officials to arrest the wave of EUR selling have been to no avail as this week’s price action demonstrates, led by a descent in EUR/JPY below 112.0 and EUR/USD below 1.22. Though sovereign primary funding requirements have moved into the background following the successful disbursement of EU funds to Greece on Tuesday and the decent sponsorship of EU debt auctions, fears of counterparty risk have not disappeared and continue to put upward pressure on libor/ois spreads. Disjointed observations by the EU ‘elite’ have not persuaded market practitioners to wade back into the EUR, even at the lowest level in four years vs the USD Risk reversal skews heavily skewed towards EUR puts vs USD and JPY. For EUR/USD, Lloyds lowered our short-term target to 1.20 where multiple layers of options structures are likely situated and so should in theory offer good protection. Follow-through buying on the EU750bln eur backstop mechanism never quite materialised. The ambiguous EU statements mean EUR/USD is set to remain a moving target in the short-term. The prospect of EUR reserve holdings being more actively diversified is especially true for the developing economies where most of the re-balancing vs the USD had taken place over the last decade. A 1.5% decline in EUR holdings in developing economies (allocated reserves only) corresponds to $32bln, though it could result in the EUR settling at a lower future equilibrium rate vs the USD. For global reserve holdings a 1% drop in EUR holdings corresponds to roughly $45bln, though again we specify that is based on allocated reserves only (i.e. 60% of the total reserves).

The contents of this report are for information purposes only. It is not intended as a recommendation to trade or a solicitation for funds. The author(s) cannot be held responsible for any loss or damages arising from any action taken following consideration of this information.

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