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After yesterday's major moves in stocks and FX markets, today it is the bond market's turn. Italian 10-year yields have fallen below 7% for the first time in 2 weeks. This has been mirrored across European bond markets and even German yields have started to retreat, possibly as a reaction to the prospect of greater IMF involvement as Europe tries to find a solution to the debt crisis.
Both Spain and France had successful debt auctions today selling EUR 8.1 billion of debt earlier in the European session. But there was a sting in the tail for Spain. Although its 5-year debt auction was more than twice over-subscribed, the average yield Madrid had to pay was 5.44%, the highest level since 2005, and significantly higher than the 4.84% it had to pay at its last auction in early November. So although investors are happy to buy Spanish debt, it could be a long time before sovereign problems in Europe are stabilised allowing for a meaningful drop in borrowing costs for Europe's most financially-troubled states.
There was better news for France. It sold EUR 1.57 bn of 10-year debt for a lower yield compared to an auction a month ago, at 3.18% vs. 3.22%. French yields have duly dropped across the curve. This is also helping to alleviate pressure on German yields, as Germany needs France to be financially healthy to share the burden of saving the Eurozone.
So we have seen a broad-based improvement in sentiment towards European debt that suggests there has been a sea-change in the way the market believes this crisis will end. There is now some optimism that the matter will be dealt with and Europe's leaders will take sensible action - at last - to foster greater fiscal union that will eventually lead to Eurobonds. Yesterday's central bank action had a major symbolic impact on the market and it has built expectations that EU leaders will act in a similarly bold, unified way at next week's summit.
We have been disappointed before, however the market does tend to be overly expectant leading up to big Eurozone meetings so talk of bold measures being agreed next week is nothing we haven't heard before. The main thing that worries us is the time lapse between agreeing on fiscal union and implementing it. In the interim Spain and Italy have to auction more than EUR 450bn of debt in 2012, so what happens then?
We believe there needs to be a bridging solution between where we are now and fiscal unity and that can only be provided by the ECB. However, the ECB is unwilling to jeopardise its balance sheet by printing money and buying the billions of sovereign debt required to bring yields back to sustainable levels unless fiscal unity is in place. This might not be on the markets' minds right now as yesterday's move by global central bankers has helped to reduce fear and inject confidence back into jittery markets, however it is worth considering as it could give a nasty reality shock at some stage.
However, we believe that the liquidity drive is enough to sustain the rally in risk for the next week at least. Not even ECB President Mario Draghi's statement to the European Parliament in Brussels could disrupt things for two long, even though he categorically ruled out buying more debt until there is fiscal unity in place. However, even though the ECB may refrain from a more pivotal role as lender of last resort for now, the Bank has embraced its role as liquidity provider de-jour for stressed European banks. We think it will cut interest rates next week and further extend its lending programmes so that banks can get access to plenty of euro to cover those pesky sovereign debts eating away at their balance sheets. So it could be central banks to the rescue once again next Thursday.
The title of this piece refers to testimony by Bank of England Deputy Governor Paul Tucker. He said at a Financial Policy Committee press conference that in the next few months anything can happen and that current conditions are exceptionally perilous. Even after the liquidity injection that he would have agreed to, Tucker urged banks to do what they can to lift capital levels.
Elsewhere, the downgrade of France's credit rating by agency Egan Jones hasn't dented sentiment towards the euro. It downgraded France to A- from AA due to the sharp rise in its debt-to-GDP ratio, which has jumped by more than a fifth in just a few years. This is unsustainable, according to Egan Jones, especially since the growth outlook for France is so weak. However, Egan Jones is considered a small player thus the market isn't paying too much attention right now.
The weak Chinese PMI data for November has been shrugged off by the market and AUDUSD is back above 1.02. This may be because the authorities cut the RRR yesterday and has started to loosen monetary policy, which could boost sentiment in the manufacturing sector over the next few months.
Price action is fairly normal for the day after the biggest rally in 3-years. Stocks are slightly lower as investors weigh up the chances of whether this is a major turning point. The euro has sustained its gains, although it continues to get thwarted at 1.35. This is a stiff resistance level, but the bulls are giving it their best shot. Above here opens the way to 1.3540 in the short term then to the 1.3585 prior highs from mid-November. Strong US data later on could boost US risk assets like stocks relative to their European counterparts. Eurozone PMI was confirmed at an extremely weak 46.4 level for November, likewise UK manufacturing remains in the doldrums at 47.6, indicating contraction territory, so today's ISM data could reinforce the two-speed economy in the western world with the US rushing ahead and Europe stuck in a mild recession.
United States 13:30GMT/ 0830 ET Initial Jobless Claims (Nov-26) exp 390k, 393k last
United States 15:00GMT/ 1000 ET ISM Manufacturing (Nov) index 51.8 exp, 50.8 last
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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