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The markets' initial reaction to the ECB meeting on Thursday has been one of disappointment. There was no big bazooka from ECB President Draghi. Instead he called for governments to stand ready to "activate the EFSF/ESM in the bond markets when exceptional financial market circumstances and risks to financial stability exist". He also said that the ECB, within its mandate, could "undertake outright open market operations" of a size "adequate enough to meet its objective". Thus, Draghi has said that there could be official buying of Spanish and Italian bonds by both the EFSF/ ESM and the ECB but only if the situation gets out of control. So does that mean that bond yields need to rise above the 7%/ 8% mark before the ECB will act?

Draghi back-tracks from London

Draghi's press conference had a much more muted tone relative to his remarks in London last week when he passionately said the Eurozone was here to stay and that the ECB would do all in its "mandate" to ensure the euro survives. It appears that Draghi's comments in London meant that the Bank won't protect the Eurozone right now, instead the ECB will avert disaster only when the euro looks like it is under severe attack. Draghi may have referenced the ECB's mandate many times during his speech in London, but he must have known that the markets are jumping on the back of central bank comments even more so than they are on fundamentals, so he should have been more careful if he wanted to avoid a "disappointing" market reaction after his press conference.

This meeting has dealt a blow to Draghi's credibility, and the mixed market reaction shows that the ECB's communication skills may need some work. EURUSD bounced around 230 pips during the press conference, and Spanish 10-year bond yields surged 35 basis points to a whisker below 7%. Since central banks hold the key to whether markets rally or sell off, the lack of ECB action at Thursday's meeting could be self-fulfilling. If it causes investors to panic and Spanish and Italian bond yields to rise sharply, it may eventually force the ECB to re-activate its bond buying programme sooner rather than later.

The euro went straight up then straight down on Thursday afternoon and money flooded out of risky assets and into the safe havens like German Bunds and Treasury bonds. The Spanish Ibex index collapsed 7% during Draghi's comments and Europe's banking sector declined by a hefty 4%.

Kicking the can down another long road

So what is next for the Eurozone? It's quite hard to tell. The ECB seems to have been dictated by the German Bundesbank. The head of the Bundesbank said in comments during an interview in late June that the ECB can't over-step its mandate, and also that it can do less than some governments think it is capable of. It added that the German central bank was the largest in the Eurozone and thus had a bigger say than others, presumably Greece or other bailed out nations. If the ECB doesn't act then it is up to the governments of Europe to resolve this crisis and that does not seem likely, at least not in the near-term. This leaves markets without an anchor until the next EU summit in October.

Until then we expect markets to meander lower, unless there is a sharp decline in credit worthiness of Spain or Italy. EURUSD may have lost control of the 1.23 handle on the back of the ECB meeting, which leaves 1.20 in view. However, a decline below the June 2010 lows may not be as likely as some think, because the markets will expect central banks to react if volatility gets out of control. This leaves the markets without any clear direction for the next few weeks, which could limit the downside in euro-based assets.

Euro weakness could persist

The euro is likely to remain an attractive funding currency, so rather than looking at EURUSD a short EURSEK position could profit in this environment. Although this cross is already at record lows, there could be further momentum to the downside as Europe's authorities and now its central bank do nothing to ease credit risk in the region, which is currency negative. Also, the relative growth potential between Sweden and the Eurozone remains wide, with Sweden getting off to a good start with a positive jump in its PMI manufacturing survey for July after a strong second quarter. A move lower to 8.2 and then potentially to 8.0 could be possible in the absence of official support to draw a line under the Eurozone's sovereign debt crisis. This cross is starting to look oversold using the daily RSI, thus any bounce towards 8.3, even 8.3250 (the recent high) could be a good selling opportunity.

EURSEK: daily chart



Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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