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Euro sentiment improves slightly

Like after the Lehman collapse, any signs of crisis, regardless of their origin, are currently triggering an automatic flight into the dollar.
Weak US labour market figures and ambiguous comments made by the new Hungarian government about the state of public finances caused this type of panic reaction at the end of last week. Against this backdrop, EUR-USD started the week on a new 4-year low, dropping temporarily to well below 1.19. At the same time, the US dollar strengthened against almost all major currencies, including safe haven currencies such as the Swiss franc. Against carry trade currencies like AUD and NOK, the dollar gained even more ground than against the euro.

During the course of the week, however, things began to calm down. Firstly, Hungary managed to iron out the misunderstandings to some extent. The corrective budgetary policy measures recommended by the IMF seem to be taking effect, and the new government is apparently committed to the budget deficit reduction target. Portugal and Spain successfully launched bonds in the market, which was also seen as a good sign. Furthermore, the Eurogroup finance ministers have now set up the European Financial Stability Facility (EFSF) as the key part of the €750bn euro rescue package. It looks as though the EU will be able to implement the package sooner than expected. Last but not least, the German Constitutional Court refused to issue a temporary injunction applied for by a German member of parliament against Germany’s participation in the rescue package.

Some reasonable economic data also show that the global economic recovery is continuing: in Germany, for instance, industrial new orders and industrial production rose again significantly in April, and Italy’s production figures were also quite positive. China posted unexpectedly strong growth in foreign trade, and production and retail trade data confirm that robust growth is continuing – perhaps gradually slowing down somewhat. Australia’s labour market figures were good.
Moreover, the debt crisis did not stop the Reserve Bank of New Zealand from increasing interest rates for the first time by 25 bp to 2.75%; Brazil’s central bank also maintained its tightening stance, raising the SELIC target rate by 75 bp to 10.25%.

The ECB is sticking to its decision to restore normal functioning on markets by purchasing government bonds. Although at the press conference, Jean-Claude Trichet emphasized that this – like all the other special measures – was only a temporary measure, he gave no information regarding quantities or timescales. Furthermore, the ECB will issue the three three-month tenders in the third quarter at a fixed rate with full allotment. The assessment of the economic outlook remained basically unchanged, but the projected timescale has changed: compared to the March projections, recovery is expected to be somewhat more robust in 2010 (1.0% rather than 0.8%), but could slow down slightly in 2011 (1.2% rather than 1.5%). The ECB is stressing the uncertainties even more than before, however. Inflation expectations for this year have been revised upwards (1.5% instead of 1.2%), but remain moderate and virtually unchanged for 2011 (1.6% instead of 1.5%).

In the run-up to the ECB Council meeting, there had been rumours and speculation in the markets about additional easing measures; there was even talk about the possibility of another interest rate cut. Against this backdrop, the ECB’s calm attitude helped the euro to rise to over 1.21 against the dollar.

On the whole, anti-euro sentiment in the forex markets seems to be dying down somewhat. If investors were to reduce their still extremely bearish positions, this could support the euro in the short term (see chart). The longer term outlook still remains very uncertain, however: many investors are jittery, which is bad for the euro, and, even if concern about the economic situation turns out to be exaggerated, monetary policy tightening in the eurozone is likely to be cautious and relatively late in an international comparison, which is also weighing on the euro. Thanks to the establishment of the ESFS and the introduction of national consolidation measures, credit default risks for individual euro area countries have been significantly reduced – a point in the euro’s favour. Moreover, the real economy in the eurozone has proved to be quite resilient to the turmoil in financial markets. Increasing worries in the last few weeks about economic risks for China and other emerging markets seem somewhat exaggerated. Thus EUR-USD could also be at a turning point.