European Tensions Pose Systemic Risks

The euro has recovered more than two cents off of yesterday’s low set late in the North American session yesterday. Many participants seem concerned that such dramatic price action in the capital markets will elicit a policy response. Japanese officials were happy to push this and revealed that the G7 will have a conference call today to discuss the events. The risk of intervention was mentioned, but also played down as it is not a currency crisis per se.

Separately the ECB is holding a conference call with banks to ostensibly discuss funding issues. The French parliament and the lower house of the German parliament have approved the EU/IMF/Greece agreement. This has help stabilize the euro. With hourly momentum studies over-extended for the euro, resistance in the $1.2850 may be sufficient to cap the single currency, barring a significant surprise in the US jobs data or from policy makers.

The indeterminate UK election outcome has crushed sterling. It fell 2% against the US dollar in mid-morning turnover in London. It was off closer to 3% against the euro. Herein lies the rub: The Conservatives have a plurality of seats, but not a majority. Convention has it that under such conditions the sitting Prime Minister is given the first chance to put together a government. The problem is that Labour, even if they could get the Lib-Dems to agree to a coalition, they still would not have a majority. It would seem to point to a Conservative-Lib-Dem government, but Labour will resist and smaller parties outside of England that might be in play.

Sterling appears better positioned to trade higher in the North American session today than the euro. There is scope for a move back toward $1.4750. This is points to the risk that sterling recoups some of its dramatic losses against the euro. The euro had moved just above GBP0.8800 before stabilizing. Near-term potential extends back to GBP0.8600.

The European sovereign debt crisis has significantly impacted liquidity and the global banking system. It is not (yet) as bad as in 2008, but the strains are intensifying. Japanese officials complained that the “Greece problem” was impacting Japan. Three-month TIBOR had its biggest rise since mid-06 as banks scrambled to swap yen for dollars. The BOJ injected JPY2 trillion into the banking system—the first one day operation of the year. There was a surge in demand for overnight euro funding as well. A number of banks have been cited by the news wires reporting of insufficient funding in the market. In the US, the basis-swaps market clearly reflects the grab for dollar funding. Three-month dollar LIBOR was fixed today at its highest level since last August. The increased tensions in the money markets may have been an unintended consequence of the ECB’s decision yesterday not to take any new measures.

Many observers and officials were previously concerned that the involvement of the IMF would cause of loss of face. Fair enough; but the global contagion caused by this crisis seems to be creating its own loss of face. The ECB has backed down on several occasions in recent weeks and it appears to be setting itself up for another one. There is likely to be greater international pressure, as well as pressure from member banks to address the liquidity situation. And rather than doing it at yesterday’s ECB meeting, Trichet and Co. may be forced to do it before next week’s repo operation.

Measures could include reinstituting some of the term liquidity provisions that it let wind down as the recovery was taking hold. In addition, the dollar swap lines with the Federal Reserve can be re-activated.

Some thoughts about the US employment data: With markets in crisis mode, it is understandable that the US employment data may not be the main focus. However, from an economic point of view, and therefore ultimately for investors, it remains an important release. The take away for medium term investors is that the US labor market is improving, ever so slowly. Barring a major surprise, the US likely grew jobs for the fourth time in six months. The private sector will likely have added jobs for the fifth month in six.

Two components of the report typically do not draw the attention from investors, but are important. The first is the workweek. Given the size of the labor force, every 0.1 increase (6 minutes) is the equivalent of around 300k full time workers. The work week is expected to have risen 0.1 to 34.1. This would represent a 0.3 increase since December. This is almost a million jobs—or really the output and income of a million jobs. And that is really the second point is earnings. Hourly earnings are ticking up, but of course constrained by the large pool of unemployed and underemployed. The take away message is that in the US more people are working, a longer work week, earning a little bit more money. All too slow, but the direction is right.