World First Morning Update 31st October 2011: European optimism fades with summit hangover, Japanese intervene

We warned on Thursday that the rally by risky assets and, in particular the euro, may have a short shelf life and that it had all the hallmarks of an “Emperor’s New Clothes” rally; the masses jumped into a moving market and are starting to leave as doubts have crept in over the viability of the decisions made last week. The main beneficiary has been the US dollar with it gaining 1% overnight against the euro while GBPEUR is back above the 1.14 level and we expect to remain in the 1.14-1.17 range through the week. Equity markets are expected to open in the red as well.

Friday was a very quiet day after all the fun and games of Thursday’s market. The main news was a poor Italian bond auction that saw borrowing costs rise past the 6% level that is seen as sustainable in the long term. In fact yields increased to a euro-area high with 3 year debt posting 4.93%, up from 4.68% previously and the 10yr trading at 6.06% up from 5.86% at the previous auction. Demand was also lower as traders remain worried that the ECB’s bond buying program of Italian and Spanish debt may be brought to an end soon and they will be left with a load of unprofitable paper.

Italy will stay in the news this week with Trichet stepping down from the ECB and Mario Draghi taking the hot seat as his replacement. This month’s ECB meeting is on Thursday so he is straight into the game and we hope that he does the sensible thing and cut interest rates. Nowhere has been hurt more by a central bank’s anti-inflation paranoia than Europe and Draghi can start his tenure on the right track by easing prospects for consumers and businesses by cutting rates by at least 25bps. The consensus view from analysts however is that rates will stay at 1.50% on Thursday with only 6 of the 54 analysts surveyed expecting a cut. His answers in the press conference surrounding ECB bond purchases will also come under close scrutiny.

Overnight we have also seen a huge intervention by the Japanese authorities  to weaken the Japanese yen. JPY lost around 4% after the authorities in Japan decided enough was enough and tried to alleviate some of the recent pressure on their beleaguered exporters. The Bank of Japan alongside the Ministry of Finance will need to show resolve in this move however as it seems that European markets are more than happy to try and fade this rally and buy the JPY back. This however has been the 3rd intervention by the Japanese authorities to weaken their currency with the first two a resounding failure unfortunately.

The main release from Europe today is the Eurozone “flash” October CPI. German retail sales for the month of September have added to the pressure on the German and European economies as they showed that sales expanded by only 0.4% against an expected view of 1%. CPI is expected to moderate slightly lower in October, although price levels have been difficult to predict of late. We also have the Chicago Purchasing Managers number at 13.45 which will key ahead of global PMIs and ISMs published towards the end of the week.

Latest exchange rates at time of writing