European Weight Returns

The pessimism over the US dollar expressed last Friday after the disappointing US jobs data has eased. The market's focus has turned back to Europe. Finance ministers meet today and tomorrow and appear hopelessly divided over how to restore market confidence. The IMF reportedly is calling for an increase in the EFSF and ECB bond purchases. Belgium, which has turned in among the worst euro zone bond performance over the past month, and holds the rotating EU presidency, though it continues to struggle to put together a government since the summer elections, supports the idea, but Merkel and Sarkozy have opposed.

Recall under the EFSF, countries are providing guarantees behind bonds and are not providing direct funding. The EFSF will issue bonds shortly (~8 bln euros) to cover part of the Irish package. There is still plenty of capacity to issue more. We have long argued that there was less to the EFSF that met the eye due to the need maintain AAA rating when most members are rated lower. However, to increase the guarantees now could signal that officials are preparing to have to come to Spain's rescue, as there are surely enough funds to cover Portugal.

There has been some suggestion, from some like Eurogroup head Juncker, that there could be a European bond, but Germany is again cool to the idea on grounds that it may be more difficult to enforce fiscal discipline. That leaves the ECB as the main institution that can act. The ECB is believed to have stepped up its purchases of sovereign bonds at the end of last week. The market will look at today's announcement of the weekly fixed-term deposit announcement insight into the size of the bond purchases.

The market will likely be disappointed as the bond purchased last Thursday and Friday may not settled. In addition to headline risk from this and the finance ministers' meeting, the market will also watching indications from two Irish independent members of parliament (Lowry and Healy-Rae) to learn their voting intentions at tomorrow's key Irish budget vote in parliament. This is more important than the fact that LCH Clearnet is going to reduce the extra deposit (margin) for Irish bonds to 30% from 40%.

Note that Moody's cut Hungary's rating two steps to Baa3 on grounds that temporary measures to fill the budget gaps are not sustainable. The outlook remains negative suggesting scope for additional downgrades. This obviously weighed on the forint and Hungarian bonds.

The Japanese yen is trading firmly on the crosses, but is confined to narrow ranges against the dollar. The DPJ government is struggling to gets its supplemental budget through parliament and what the press is calling a "light-hearted" remark about the budget has cost Justice Minister Yanagida his job. Japanese government bonds had the biggest rally in two weeks (10-year yield eased 5 bp). This week's supply is of secondary importance compared with expectations of another poor machinery orders report on Wed.

The euro has retraced the lion's share of the pre-weekend, poor US jobs report inspired gains. Friday's low was set near $1.3193 and this corresponds today to the 5-day moving average (~$1.3200). Below there, the $1.3150 area is a retracement objective. Sterling will likely find some support in the $1.5635-50 band. A convincing break could signal a move back toward the $1.5550 area. There is a string of UK data this week and an BOE meeting that highly unlikely to take any action. While the dollar recovered against most of the major currencies, it is flattish against the yen, being confined to a 25 tick range on both sides of JPY82.75. A break of JPY82.50 likely will require some worsening of the news stream or deterioration in the financial markets.