12 September 2012 Is Europe Improving? There was a continued risk feeling in the financial markets last week. There was a fairly substantial rally in European equities, which have risen by around 6% over the last few weeks. There was also a sustained rally in the UK and US markets, which rose by about a couple of percent or so. Markets including Hong Kong and Japan saw lower gains, up by only around 1% or so, while larger emerging market economies did slightly better.. Confidence has returned to European assets. The euro strengthened against the US dollar, but this should be seen in context of a weakening dollar. In the commodity markets, oil and industrial metal prices have flattened, but the rally in the gold markets has continued - it is up around 10% or so over the last few weeks. Peripheral yields fall on ECB comments In the government debt markets, there has been continued stability in high-quality sovereign yields of countries such as the US, the UK and Germany, but these have not responded to the risk-on tone in equity markets by rising, as might have been expected. There was a rally in peripheral bond market prices, with Spanish 10-year yields falling from around 7% to 5.5% over the last few weeks. This was driven by comments by European Central Bank (ECB) President Mario Draghi at his monthly press conference following the bank’s rates decision. Last week, the ECB announced what it intends to do to intervene in support of financial markets. There was some indication of this earlier in the summer, but last week the ECB provided clarity on this. Draghi’s promise comes to fruition The ECB’s intention is now very clear. Draghi said the central bank intends to provide a fully effective backstop to remove tail risk in euro area. The ECB will attempt to do this by buying peripheral debt over a 1-3 year maturity span, potentially in unlimited amounts. This debt bought by the ECB will be ranked at the same level of authority as other private investors. Eurozone crisis is not over yet This is an important step forward. It does reduce the tail risk of holding sovereign debt, but it does not solve the European debt crisis. What it does do is provide more time for some structural reforms to be implemented. Some things within the euro area are still vulnerable. There is no banking union - work has begun on this but it will be months until this is properly set up. There is considerable debate about the structure this will take.
As Europe’s financial problems continue, and until there is greater clarity on which financial institutions are strong enough to survive and which are not, this will be an ongoing problem in the development of the eurozone. Government debt debate begins The debate on mutualising government debt has begun, and this is an important solution to help solve the European financial crisis. All of this is taking part while the eurozone is still in recession, which is also now broader. Europe remains locked in this vicious circle of fiscal tightening and bank deleveraging, while the increasingly active ECB is not yet able to break this cycle. In conclusion, the ECB intervention is an important step forward. It is right to think that tail risk is subsiding, so the rally in European risk-assets is not ill-founded. Nevertheless, there are considerable challenges ahead until the euro area can find stability. Currencies On currency markets, comments from the ECB helped the euro strengthen against most of its trading partners over the week. Elsewhere, the dollar weakened against most currencies after the weak jobs data. The €/$ rate ended the week at €1.28, a strengthening of almost 2%. Oil Oil prices started the week poorly, but gained late in the week amid expectations of monetary stimulus worldwide. The strengthening euro also contributed to the late gains. The West Texas oil price ended the week unchanged, slightly above $96 a barrel, after paring all of its losses. Elsewhere, gold rose 3% to $1,737. Bonds Bond prices of the eurozone’s most indebted countries, most notably Spain, rose sharply, with 10-year bond yields in Spain 2% down from recent highs. This followed Mario Draghi’s announcement of the ECB’s new bond-purchase programme, to which investors responded well. The bank has agreed, in principle, to an unlimited debt-purchase programme to cap borrowing costs for peripheral nations that have applied for official aid from the EFSF/ESM. This decrease in perceived risk attached to peripheral country bonds resulted in prices of core countries, including Germany, falling over the week. The Merrill Lynch over 5 year government bond index ended the week 1.2% higher.