Europe Center Stage

The European debt crisis and the policy paralysis continues to dominate the capital markets. The euro has been driven lower, breaking below the 200-day moving average in Europe for the first time since January 12th today, before recovering following respectable bill auctions in Italy and Greece and talk that the ECB broke a couple month hiatus and intervened bought sovereign bonds. The euro bounce is unlikely to be sustained. Look for the $1.4000-$1.4050 area to now denote upper end of range.

European officials are promising a new strategy shortly and of course in this environment can the new IMF head say anything but that it is not presently talking about a second Greece aid package. European officials are not ready. They do not appear to know what to do.

The Dutch (as in people from the Netherlands, as opposed to the husband of this lady) claim that a Greek default is not longer excluded from discussions makes intuitive sense, but is dangerous on two grounds--undermines current investor sentiment further and (here is where there is contagion), investors realize if EU allows Greece to default it increases the risks (not diminishes them) that Ireland and Portugal may also be allowed to default.

European officials are apparently reconsidering EFSF enhancement, which may include bond purchases, directly or indirectly (ie lending money to Greece to buy their bonds back at a deep (and getting deeper) discount. Germany has consistently opposed.

Italian bill yields rose sharply (3.67% from 2.14%) at the 1-year bill auction vs last month's auction. The auction of 6.75 bln euros was covered 1.55 times, down from 1.7 times. Yet given the conditions, it was seen as a relief. The bond auction is Thursday and it is more important. The Greek bill auction was even better. The yield on the 6-month bill slipped 6 bp to 4.9% and the bid-cover increased to 2.88 from 2.58.

Ideas that the new EU plan will lower interest rates on aid and lenghten maturities is too little too late. Reducing debt servicing costs is insufficient to get closure. That said, given that fact that France had been demanding Ireland raise their corporate tax shedule rate, succh a concession is not just a victory for Ireland, but another defeat for Sarkozy who's plan for Greece debt roll-over scheme looks dead.

Two other devleopments to note today. UK reported a softer than expected CPI. This not only weighs on sterling directly, but it is also may increase the chances on the margin ofanother round of asset purhcases should the UK economy falter. It also reported a much larger than expected trade deficit.

The BOJ left rates steady as widely expected. It revised up its assessment of the economy for the second month. The dollar broke down just below JPY79.20 as flight to safety. Fears of intervention and the bounce in the euro and recovery in the European debt markets helped lift the dollar back to JPY79.80. This is not the condition for intervention. Intervention, as we have argued, is more a funciton of voliatility than levels. Dollar-yen vol remains low (3-month imp;lied below 10%).