European Developments in Focus

The absence of fresh developments over the weekend encouraged euro selling today. Before North American traders returned to their posts, the euro has already retraced 50% of the gains in the second half of last week. The next retracement objective is seen near $1.2346. Recall last week’s low was recorded mid-week near $1.2144.

News that the Spanish central bank had to rescue a savings bank is more suggestive of the underlying problems than substantive in its own right.

Meanwhile, most of the reports from the summit at the end of last week have focused on the tightening of the fiscal rules in the euro zone, including enhanced monitoring and enforcement. However, what seems to be even more significant is the effort to include a mechanism to manage sovereign insolvency. This seems the logical conclusion of efforts to make the ECB a truly lender of last resort. Some initiatives were defeated. These include efforts to centralize fiscal policy and to develop a euro zone bond market. Details on the mechanism for managing sovereign insolvency are vague, but this bears monitoring.

Another development should not be lost in the constant barrage of news are the reports that France’s Sarkozy threatened to drop out of the euro zone in an effort to get Germany to agree to the Stabilization Mechanism. Contacts report that Germany is still irate about such tactics and the unilateral ban on some types of naked short sales need to be placed in that context. EU Commissioner Michel Barnier, a Sakrozy ally, had not wanted to present a new regulatory framework until October. German domestic political considerations could not wait that long. Merkel’s government had to promise tougher rules for euro zone fiscal policy and curbs on speculation in the financial markets in order to ensure parliamentary support for the loan guarantees and the Stabilization Mechanism.

The European debt crisis continues to impact the global capital markets and the disruption is likely adding pressure on Europe to take additional measures. The problem is that bank lending has never really returned in a significant way and now the capital markets themselves are under stress. This is evident in LIBOR rates and swaps indices. The corporate bond market in Europe has dried up with reports indicating that there has been no European corporate benchmark brought to market since May 5th. At the end of last week, despite ECB purchases, the euro zone sovereign market seized up. The fairly successful bond auctions from France and Spain notwithstanding, dealers report that sometime bid-offer spreads were 50 bp wide.

Short-term bank financing often comes from money market funds, but reports suggest many managers have shifted funds out of bank issued certificates of deposit and commercial paper into US Treasury bills. While dollar swap lines with the Federal Reserve have been re-opened, few banks have tapped the facility. The rate is too punitive compared with LIBOR rates and this suggests that the funding pressure is not as great has it had been in late ’08. Swap rates—in this case swapping euros for dollars and yen for dollars show strong demand however for dollars.