Market Takes Italy Downgrade in Stride, FOMC Injects Caution

The euro completely recovered from the down draft sparked by S&P one notch cut in Italy's sovereign debt rating.  S&P was already at the lower end of the rating agencies and many expected Moody's to move first.  Moody's says it needs another month or so to work through its review.   The euro had dropped a cent from the announcement through the Asian low, but rallied a full cent in the European morning.   

There is some risk that correction to the 10 cent drop in the euro from Aug 29 through Sept 12 is not complete.  Last week saw the first leg up of the correction, which met the 38.2% retracement near $1.39, never closing above there.  The push down Friday and yesterday has faltered just below $1.36 and that could be the re-test on the lows and the beginning of the next leg higher.  Initial resistance is seen near $1.3760 or maybe yesterday's high near $1.3785. 

Germany's ZEW survey fell to -43.3 from -37.6 in August although slightly better than some expected, it is still at the lowest level since the end of 2008.    The ZEW is not a good guide to GDP in Germany, but it does show how much sentiment has deteriorated.  Note too that the German  5-year CDS is trading at record highs today. 

Reports suggesting that the Greek government is considering a referendum on continued euro zone membership has been denied, but it comes amid increased calls for Greek to exit.  Merkel and Sarkozy came out forcefully against the idea that a Greek exit would solve either the euro zone challenges or Greece's.   Given that the muddle through strategy in Europe has driven the policy response to the 2-year old crisis , the most likely scenario still seems that Greece makes the right noises and concessions and gets the next 8 bln euro tranche of aid.   

Today's North American session is likely to be of consolidation.  The short-term speculative market is long dollars.  The greenback's upside momentum has faded, leaving the late long dollar positions in weak hands.  Some position squaring ahead of the conclusion of the FOMC seems reasonable.  Every one is talking Operation Twist, but there is a chance that the Fed also cuts in the  interest rate on excess reserves from 25 bp to say 15 bp.  It may not be a big deal or very effective, it is more that many may be surprised and see it as a "rate cut" .  Note that effective Fed funds, which is the price of excess reserves in the market has been 8-9 bp this month, which is also its 100 day moving average.