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The tone in risk sentiment has shifted throughout the London Session. After a weak start to the day European stocks markets moved higher before giving up some gains. However as we get close to the London close the euro is once again coming under pressure and the dollar is higher. EURUSD weakened to its lowest level since January and is below 1.3150.
The late afternoon dip in the euro is possibly due to German Chancellor Merkel's rejection of calls to raise the upper limit of the ESM rescue fund. It currently stands at EUR 500bn, which is unlikely to be enough to cover Spain and Italy if they need to retreat from the bond markets. Earlier she also reiterated her stance on solving this debt crisis. Eurozone members need more fiscal discipline and must keep to stability rules, she also said that the EU Treaty doesn't allow the ECB to act like the Federal Reserve in the US, and so can't carry out massive bond purchases. Many believe that unlimited bond purchases by the ECB is the only way out of this crisis, so it is no surprise that the euro has sold off and this has dragged risky assets lower. The markets are still held hostage to political risk, which is threatening to halt the so-called Santa rally.
However, to add another spanner into the works, there is always the chance that the FOMC sounds dovish when its meeting concludes later today. This helped to buoy the markets earlier. Expectations are for the federal funds rate to remain unchanged but there could be a possible cut to the interest rate banks are charged to use the discount window and access dollars, after coordinated central bank action earlier this month reduced the cost for foreign central banks' dollar swap lines with the Fed. However, that is unlikely to cause too much excitement in the market as the focus is firmly on Europe.
There was some good news regarding debt auctions that markets quickly forgot about. Spain and the Eurozone rescue fund, the EFSF, had successful debt auctions earlier. Spain sold EUR 3.4 bn of 1-year bills with a yield of 4.05%, while investors charged 4.22% to hold 18-month debt. These yields are lower than at an equivalent auction a month ago, suggesting that while strains in the currency bloc remain things may have eased somewhat.
But the big news was the EFSF. All eyes were on this auction as the rescue fund aimed to sell EUR 2 billion of 1-year debt. The auction attracted healthy interest and had a bid-to-cover ratio of 3.2, the yield investors charged to hold the debt was also a low 0.22%. We would point out that Germany can still borrow at much cheaper rates, last month it sold 6-month debt for a 0.0005% yield. However, obviously the threat of sovereign downgrades for the European countries that threatens the EFSF's AAA credit rating isn't putting off investors just yet.
As we move through the week economic data is likely to take centre stage. The German ZEW index was slightly better than expected rising to -53.8 in November from -55.3 in October. However, this index is still far below its long term average of +25 and suggests that confidence remains low in the German investment community. However, it may suggest that things are bottoming out and that German growth could pick up again in 2012.
Bank of England member Spencer Dale sounded dovish in a speech earlier and hinted more QE was around the corner. Also, the rating agencies are out in force but this time their target is Eastern Europe. Bulgaria, the Czech Republic, Latvia and Lithuania had the outlook on their long-term foreign and local currency credit ratings revised to stable from positive by Fitch Ratings. Eastern Europe is at risk from a credit crunch caused by the Eurozone sovereign debt crisis and is considered the next domino to fall.
Talk that Iran had blocked the Strait of Hormuz - a major oil route - has caused oil to surge higher today. Iran is getting bolder as we head towards the end of the year, and geopolitical risk may act as an upward pressure on commodity prices into year-end.
Overall, political risk is likely to keep things volatile this week and there could be plenty of ups and downs and reverses in sentiment to come.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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