Two Things Ail the Euro: What We Know and What We Suspect

The euro is plagued by two things: what the market knows and what the market suspects.

What the market knows has increased today with the euro zone manufacturing PMI readings for May. While readings remain above the 50 boom/bust level, the pace of activity slowed. For the euro zone as a whole the headline pace slowed to 55.8 from 57.6 in April. Separately, the region’s unemployment rate rose to a 12-year high of 10.1% in April, though Germany reported a decline to 7.7% (from 7.8% as the unemployment queues fell 45k, more than twice the consensus expectation. This plays on fears that the fiscal consolidation in Europe will slow growth. The market also learned from the EMU’s stability report that European banks may have to write down another 195 bln euros in the 2010-2011 period.

What the market suspects is that European officials are still behind the curve. Since announcing and arguably exaggerating the 750 bln euro package (exaggerated on the grounds that the 250 bln euros from the IMF are theoretical and IMF assistance has not been requested by any member outside Greece), and delivery mechanism and conditions have not been established.

Moreover, details from the term deposits at the ECB suggest it is only reluctantly buying European bonds. The term deposits are the way in which the ECB is sterilizing the purchases. Judging from this, it appears that the ECB bought 16.5 bln euros in the first week of the program, 10.5 bln euros the second week, and 8.5 bln last week, for a total of about 35.5 bln euros.

Reports suggest that every morning the ECB’s Market Operations Committee meets at the ECB and a decision is made and then the ECB with the national central banks coordinate their purchases. Both of the leading candidates to replace Trichet at the end of his term next year, Weber and Darghi advocate a quick end of the purchases. The heightened pressure in the European debt markets suggest it will still be involved. There are some reports (e.g. Spiegel Online) that suggest German banks made a ‘voluntary’ commitment to the Finance Ministry not to sell Greek bond holdings, while there is concern in Germany that French banks have been eager to sell their Greek bonds to the ECB.

The Bank of Canada meets today. All of the primary dealers in a Reuters poll expect a 25 bp rate hike today, the first in the cycle and the first from a G7 country. A Bloomberg survey found 25 of 27 respondents expect a hike today. Yesterday’s stronger than expected Q! GDP data (6.1% annualized pace) and the record April jobs gains underscore the strength of the Canadian economy. The setback in the Canadian dollar, which has slid more than 5% in the last six weeks, may mitigate one obstacle to a rate hike (namely currency strength).

The main weight on the Canadian dollar appears to be emanating from unwinding risk on trades and the pullback in commodity prices, rather than something Canadian specific. We continue to favor the Canadian dollar for medium term investors. A rate hike today by the BOC, though may also help another currency, the Swedish krona, albeit indirectly.

Here is the logic. Sweden’s economy is chugging along. Bucking the trend of softer PMI readings, Sweden’s manufacturing PMI rose to 66 from 64 in April (the consensus was for a decline to 62.3). The Riksbank’s stability report underscored the relative health of the Swedish banking system. The Riksbank meets on July 2. Although Sweden is of course more integrated into Europe than Canada, if European financial crisis does not prevent the BOC from hiking, it may not stop the Riksbank either. Long Swedish krona against sterling looks attractive from the technical and fundamental vantage point, though the UK did report a better than expected manufacturing CIPS (58 vs 57.9 consensus).