Euro finally manages a bounce as risk assets continue to rally

Tom Tong23/Ιαν/2012Currency Updates

After many weeks of nearly uninterrupted declines, the common currency finally staged a decent rebound last week. Succesful soverign debt auctions, the relative lack of catastrophic news, and most importantly, the record short positioning and overwhelming bearish consensus surrounding the Euro gave the currency the short term lift we had been calling for since late 2011. It finished the week up a sharp 1.5% against the dollar, which means that it has recovered all of its 2012 losses. Stocks and commodities worlwide also rallied, and the dollar confirmed its status as a safe-haven by moving in the opposite direction: the Dollar index gave up over 1% for the week.


Inflation continued its sharp drop last month, as the last VAT increase drops out of the calculation. Headline inflation dropped 0.6%, from 4.8% YoY to 4.2%, and it is widely expected to continue to do so over the coming months. Unemployment surprised to the upside, up 0.1% in the month to 8.4%. Next week we get 4Q GDP growth, which we expect to be a negative number and the beginning of a short, shallow recession. Macroeconomic data continues to print soft, proving the doves at the Bank of England correct, and supporting our view that the quantitative target of Gilt purchases will be increased again this quarter. Meanwhile, Sterling continues to shine. It managed to keep up with the rally in the common currency, and it rose sharply against the dollar. We think that this performance is being helped by the relatively light positioning in the markets on GBP, and once the level of Euro shorts decreases somewhat, we expect it to revert to form rising against the Euro but dropping against the US dollar.


Sentiment around the common currency improved markedly last week. We described back in December the process by which Draghi´s ECB is effectively supporting Spanish and Italian bonds through the back door, avoiding the direct purchases that anger German politicians so much. Instead, the ECB is using its local branches (the Bank of Spain and the Bank of Italy) to pressure their respective domestic banks to avail themselves of the massive liquidity injections by the ECB, and then use that liquidity to buy the sovereign bonds. Successful debt auctions in 2012 have brought down yields on peripheral debt significantly, although we fear not enough for medium term sustainability. The backdoor bailout described above has finally filtered through to consensus opinion. This change in sentiment, combined with the massive short position that traders hold against the common currency, brought about a sharp rally in the Euro last week. The common currency recovered all its losses for 2012, and we wouldn´t be surprised to see the rally continue in the short term, while macroeconomic news remains light and the EUR shorts rush to cover their positions.


The main macroeconomic news in the US was a downward surprise in the inflation rate. It appears clear that the downward shift in inflation is a phenomenon common to all advanced currencies, as similar trends have established themselves both in the UK and the Eurozone.These developments support the dovish views of the Federal Reserve, and are a sharp rebuke to the misplaced obsession with inflation displayed by the ECB under its previous head, Trichet. Absent any other market moving news, the dollar was content to drift downward as risk assets rallied and capital flew out of safe havens like the greenback and into risky assets like equities.


Written by Tom Tong

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