London Update: Tight Ranges Persist as Europe Plays Hardball

The fundamental news flow today has been euro positive, bar one very important fact: the EU, ECB and IMF are playing hardball and at the last moment last night rejected the IIF’s “final offer” to reduce Greece’s debt burden. Initially this dented sentiment and EUR/USD fell below 1.30, but it found good support at 1.2990, and since then has been trading in a fairly choppy range between 1.2990 and 1.3060.

The Eurozone finance ministers who met yesterday barely hid their disapproval with Greece for continuing to miss its fiscal targets. However, months ago the Greek growth outlook was revised sharply lower – growth isn’t expected to return to the Med nation until at least 2013 – which suggests that perhaps fiscal targets are unrealistic so should be revised to better reflect Athens’ hobbled economic condition.

But while fiscal targets are missed then the pressure is heaped on the private sector to agree to harsher terms in their debt swaps. So far the IIF have been resistant to this, but Venizelos – the Greek fin min – said that a new round of talks will aim to be completed by Feb 1st, so yet another deadline has been missed by Athens.

The problem is that the more pressure on Greek bond holders to accept losses then the more pressure on Europe’s banks that hold Greek debt. This is particularly acute for French banks, six of which were downgraded by rating agency Standard & Poor’s last night including Credit Agricole and Societe Generale. Europe’s overall banking stock index has fallen today, which has weighed on the Eurostoxx index and has caused it to edge away from key resistance at 2,470 – the 200-day sma.

But balancing the bad news is the economic data of the Eurozone today, which was particularly encouraging. PMI’s for France and Germany surprised to the upside. Germany's services sector PMI jumped to 54.5, its highest level since June 2011. This helped to push up the Eurozone composite index into expansion territory to 50.4 from 48.3 in November. This suggests that growth may have bottomed in the last quarter of 2011 and started 2012 on a brighter note.

Although the improvement was led by Germany and some modest improvement for France, even some of the weaker states saw their readings improve although they still remain deep in contraction territory. Services outperformed manufacturing, however, worryingly; the employment sub-sector of the Eurozone index actually fell in January, although activity expanded. In-flows of new business were also lower, which may account for why firms were cutting headcount this month. So although the headline index is good, the detail suggests growth might not bounce back as we enter 2012 and it could be more of a slow grind higher.

There was more good news in the sovereign space also. Spain sold more than its target of short term debt this morning. Madrid attracted demand for EUR2.51bn of debt, more than the EUR2.5bn expected. Yields also continued to fall; the average yield was 1.285% vs. 1.735% at an auction back in December.

An interesting development is happening in the Eurozone credit sphere. Investors seem to be differentiating between those countries with just bad finances (Italy, Spain) and those where the problems are more acute (Greece/ Portugal). Portuguese 10-year yields are still above 14%, more than double the rate for Italy. As long as problems in the less bad peripheral nations continue to improve then we believe that the euro and other risky assets should continue to out-perform.

Elsewhere, the UK released public finance data for December this morning. The data showed the deficit narrowing more than forecast in December as government spending fell. Net borrowing was GBP 13.7bn, vs. GBP15.9bn a year earlier. This comes at a good time for the UK as the rating agencies have been only too happy to cut triple A credit ratings from those who are less than fiscally virtuous. Gilt yields have been rising since the start of the year but they came off a little today as overall risk sentiment moderated.

Ahead today the focus will shift to the Federal Reserve meeting, which concludes tomorrow. Ranges are likely to persist until then. EUR/CHF is falling sharply today and reached its lowest level since September at 1.2058. The SNB’s Danthine speaks today at 1615GMT; he will have his work cut out to persuade the market that the SNB is sticking to its 1.20 target. If he fails then we could see the markets test 1.20 and more EUR/CHF weakness to occur.

Markets are likely to be choppy and range bound in the near-term as a mixture of profit taking and the failure to strike a deal between Athens and its private sector credit holders limit upside, although as long as the sovereign space continues to recover then support levels in euro, Aussie and stocks should hold.