Euro Crushed, Dollar Firm

The US dollar has begun the new week on a strong note, although there appears to have been little progress on the debt ceiling talks.  The European debt crisis is simply eclipsing the US debt situation as there seems to be a a consensus that at the last minute US politicians will find a resolution.  The European debt situation is seen a more intractable. 

The key event of the week is the Thursday European summit, but Merkel is already indicating that if there isn't a deal, she won't be attending.  The stress test results were not very satisfying and this has kept pressure on the peripheral bond markets and bank share prices.    Of note, Spanish 10-year yields are making new euro-era highs near 6.30%.  There is speculation that LCH Clearnet, a key clearer/platform for trading European bonds may increase the margin required on Spanish bonds due to the volatility.  And Italy is flirting with the 6% level.   Moody's warns that the new austerity measures, approved last week, will hurt regional finances. 

Ahead of the summit, Germany releases is ZEW and IFO surveys and there is the flash PMI.  These are likely to confirm a continued loss of momentum. 

The US-German spread continues to move in the US favor .  The  spread now stands at about 80 bp, the narrowest since late Feb.  Over the past month, the US 2-year yield has slipped 2 bp, while the German 2-year yield is off 34 bp.   Although the fading economic momentum may be giving some second thoughts about an other ECB hike this year--in Q4--the decline of the 2-year yield in Germany and the decline in the implied Dec Euribor yield likely reflects, to a greater extent, the safe haven flows into Germany and into cash. 

Like others, I suspect, that if the markets really thought the US was about to default, the US 10-year yield would not have hit a new 2011 low last week, for example.  However, as the rating agencies have made clear, the wrangling over it is not helpful for the US credit outlook.     Perhaps it helps explain why the euro is still holding above $1.40.    That said, a convincing break of the $1.40 area would target $1.3840-50.    Sterling support is seen near $1.6040 and with a break opening the door to another cent decline.    The yen is largely sidelined, with the dollar confined to a 35 tick range.