EUR/USD rallied on Friday but failed to test the 1.27 level. Market sentiment was spurred by the announcement from the EU Summit, which was better than expected. While there was a lack of details there looks to be real progress on various fronts, with European officials agreeing to establish a Eurozone supervisory body for banks, and discussing the possibility for the ESM to directly recapitalize banks which would help weaken the link between banks and sovereigns. The EU Summit should be seen as a positive and should support sentiment, but focus will soon turn to Thursday’s ECB meeting where the market is broadly expecting a 25bp cut, while positive for risk it will likely weigh on EUR performance. For today, EUR/USD looks likely to remain confined to the recent range and looks unlikely to threaten the 1.2748 high seen two weeks ago.
Market expectations were very low going into the meeting and this time the political leaders managed to deliver more than expected in the market. Despite a substantial difference in opinion between Germany on one side and Italy, Spain and France on the other, Italy’s Mario Monti managed to persuade Germany to support short-term measures. The European Stability Mechanism (ESM) will be given the possibility to recapitalise banks directly, once an effective single supervisory mechanism is established. It is likely the ECB will constitute the supervisory body. This is expected to be in place by year-end. This is intended to help break the vicious circle between banks and sovereigns. Such an agreement would effectively transfer risk from bank losses from sovereigns to the ESM and thereby make potential losses a shared liability for euro member states. The mechanism might be imposed retrospectively as the EU statement concludes that ‘similar cases will be treated equally’. The main beneficiary of this would be Ireland. Regarding the aid package for Spain, it will be provided by the European Financial stability Facility (EFSF) until the ESM becomes available, without gaining seniority status in this change.
The main event in the euro area the coming week is the ECB meeting on Thursday: Danske expect ECB to cut the repo rate 25bp to 0.75% – a new all-time low. This time it is consensus expectation both in the market and among analysts, so it will be a big disappointment if Draghi hesitates again. Euro area unemployment is at an all-time high, inflation is coming down and even the core countries are in recession now. Several of the governing council members have also given weak signals that a rate cut could be coming up by saying that 1% should not be considered the floor for the ECB.
It is uncertain what the ECB will do with the rate corridor in this scenario. Danske expect the deposit rate to be cut by 10bp to 15 but it is also possible that ECB will keep the deposit rate unchanged or cut the rate by 25bp. We are in uncharted territory. Another 3-year LTRO is also an option, in particular since the eligible collateral base has been broadened again. However, Danske expect Draghi will wait another couple of months. Draghi has recently communicated that ECB is still assessing the impact of the first two 3-year LTROs and that we still haven’t seen the full effect.
There will also be a couple of interesting releases this week. Danske expect euro area unemployment to edge higher to a new all-time high of 11.1%. Final PMIs will attract attention as well, and in particular the Italian and Spanish figures. However, we are already at downbeat levels and the market is already pricing in a very negative scenario, so the release will most likely have limited market impact. Danske expect an unchanged reading of both euro area retail sales and German factory orders after substantial drops in April. German industrial production is expected to increase moderately after the sharp drop in the May figure.
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