ECU's FX Strategic Insight: Eurozone: Credit Where Credit's Due?

French, Spanish and Belgian credit defaut swaps (CDS) hit record highs yesterday as bond market concern returned after the ‘Monti bounce’ on Friday, as the naming of a non-political head of the Italian parliament squeezed short ‘risk’ positions and inspired a brief relief rally. As I alluded to yesterday it does seem like there is little that will encourage non-domestic private investors back into the bond market at this juncture outside of the unlimited support of a central bank that is willing to ‘go nuclear’ and monetise Eurozone debt. The issue remains however, that the German opposition to this strategy is still as firm as ever evidenced audibly by the European Central Bank's Weidmann as he stated that the “ECB must not become a lender of last resort” and that “monetizing debt would threaten ECB credibility.”

From a foreign exchange perspective the longer term prospects of the EUR are becoming more fragile and less dependent on the course of action of the ECB in my mind. If the ECB does not ‘go nuclear’ then Eurozone government bonds will continue to come under selling pressure as banks and investors deleverage and redistribute ‘risk’ and Eurozone bonds effectively endure a ‘buyers strike’. If the ECB were to print money or monetise debt, then the long-term implications for the EUR are likely very significantly negative also. Despite this the EUR remains surprisingly buoyant at the current juncture.

USD rally imminent?
In the US there has been some significant developments over the last days that, which have been largely unnoticed behind the intense market focus on the developments in the Eurozone. The US super committee is nearing agreement on federal debt levels, the political impasse over which caused marked downgrades of USD holdings and expectations. In addition to this the potential pro-growth policies surrounding the US tax structure debate on 21 November could also be a significant boon for the USD, this is particularly important in the US as (like the UK at the moment) there is currently an almost unprecedented amount of money on the sidelines. Any measures that make the political or regulatory landscape clearer could be sharply positive for the USD.

In Australia the minutes from the last Reserve Bank of Australia's monetary policy meeting were arguably less dovish than the market was expecting and the fact that the committee openly considered leaving rates unchanged at 4.75 percent has caused the market to doubt its expectations of a further 25bp cut at the December meeting. Ultimately though the developments in the Eurozone and their implications for global economic confidence and growth, will remain the driver of central bank, consumer, investment, and corporate decisions over the short term.  If things deteriorate in the Eurozone then the RBA, and a number of other global central banks are likely to ease monetary conditions further. 

Tomorrow I intend to make the medium-term case for GBP, but for today the market focus should remain broadly on the Eurozone. UK CPI may generate a brief moment of interest but I would expect CPI to begin to drift steadily but unspectacularly lower into 2012 and further. Eurozone GDP over that timescale is going to be much more interesting. Today we have seen the German and French Q3 GDP figures in line with expectations at 0.4 percent and 0.5 percent quarter on quarter respectively. However, Q4 and Q1 2012 are likely to be considerably weaker as Italy, France, Belgium, Austria, Holland and potentially even Germany are likely to follow Portugal and Greece into recession over the year end as austerity bites and domestic and consumer confidence, and hence demand, crumble.