The euro suffered its biggest decline in six weeks as the financial crisis in Greece is (finally) creating a political crisis. Many in the market were caught leaning the wrong way on Wed, expecting the euro bounce beginning in Europe and Monday and continued Tuesday, to see some follow through. This seemed to serve to exacerbate the euro’s slideas the weak longs cuts triggered additional stop loss selling.
There have been two main forces driving the currency markets here in H1. The divergent trajectories of monetary policy, which is a function of the policy response to growth and inflation expectations is on one side. On the other is the European debt crisis. They both share a transmission mechanism–interest rate differentials.
The Fed is still easing–for a couple of more weeks, and then simply keep its foot on the monetary accelerator, though not increasing pressure. The ECB has signaled, as much as it can without what Trichet would call pre-committing, to a July rate hike, its second. This was the main driver in the first five months of the year and the US-German 2-year note spread went from 20 bp in Germany’s favour to around 130.
However, episodically the European debt crisis would flare up and when it would, funds flowed in to the Germany debt market for safe haven, driving its rates down relative to the US. This is one of those episodes, but a particularly severe one that has seen not just Greece, but Irish and Portuguese premium and credit default swaps rise to new highs. The 2-year US-German spread well today despite the relatively soft data–industrial output, but especially the June Empire State survey.
The Greek Prime Minister Papandreou, who incidentally was born in the United States, has fared better than the PMs of Ireland and Portugal that negotiated their aid programs. However, fissures are evident and growing. There was talk that he would resign in favour of a national unity government, but that seemed to have faded for a moment and a cabinet reshuffle seems more likely, though admittedly the situation is far from clear. Including the opposition might be helpful, but might not be do-able.
Yet one cannot help but wonder if another short coming of the IMF (DSK?) and European strategy is that it undermines the very political and economic elite whose cooperation is essential. This would seem true not just for Greece of course, but throughout Europe. In this context, note that Belgium and now Finland do not have governments.
The euro is testing its 100 day moving average, which comes in near $1.4150. The 100-day moving average, which I do not use as support or resistance but a mile market, did though hold today and it held the May 23rd low just below $1.40. This is the next important target zone ($1.39-$1.40). Looking further down field, a break of that area would signal $1.36. Yet it is important to take it one step at a time, given the higher volatility and the fact that the US fundamentals are poor still. The $1.4250 likely marks near-term resistance now, with more aggressive short-term players selling into a bounce toward $1.4200.
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