An impressive rally in risk assets and higher-yielding currencies followed the announcement of an agreement on Friday between European leaders, to take emergency action to curb the rising borrowing costs of Italy and Spain. European equity markets continued to rally at the start of the week; however the European single currency slipped on downbeat manufacturing data and as the limited nature of the policy initiatives taken on Friday were more carefully scrutinized over the weekend.
Borrowing costs for heavily indebted Spain and Italy eased following the EU summit, relieving some pressure. Spain’s benchmark ten-year yields eased to 6.27 percent from its June peaks of 7.147 percent while Italy’s ten-year benchmark yields were down to 5.72 percent from its highest in June at 6.215 percent.
At the summit of euro zone countries in Brussels on Friday, leaders agreed that the area’s rescue funds could be used to stabilize bond markets without forcing countries to adopt additional austerity measures and reforms. The European Stability Mechanism (ESM) would have the ability to lend directly to banks in order to stabilize markets without increasing a country’s deficit. Despite the communique only referring to the “EFSF/ESM being used in a flexible and efficient manner to stabilize markets”, Italian Prime Minister Monti later made it clear that this in fact implied sovereign bond buying.
EUR/USD surged higher following the announcement from the summit. The pair rallied to 1.2693 on Friday, after hitting a three-week low by 1.2407, the previous day. Early on Monday, the single currency pared its gains versus the greenback, and EUR/USD eased off to 1.2568. The initial excitement was dampened as it became clearer that imminent purchases seem unlikely until outstanding issues around conditionality are fully ironed out and German Chancellor Merkel suggested that it may take “perhaps a year” until countries will be able to start using European funds to directly recapitalize banks. Further dampening hopes that a solution may at long last been found were comments by the Finnish government, which said that Finland and the Netherlands are opposed to the ESM buying bonds in the secondary market.
At the start of the week, downbeat manufacturing data out of Europe, China and the United States threatened to stall the risk recovery. Euro zone manufacturing PMIs, a gauge of manufacturing activity in the region, remained below the 50 mark indicating contraction, while China’s manufacturing PMI also edged lower. The jobless rate in the common currency area also inched higher to 11.1 percent.
The ISM manufacturing PMI from the US was also worse than expected at 49.7, the lowest in almost three years, and also threatened to hurt risk appetite. US markets opened lower on Monday but reversed their losses as investors focused on speculation that central banks will have to do more to spur growth and revive their fragile economies. On Tuesday, European stocks were higher and Asian shares rose for a fifth straight day. The yen fell sharply as forex investors cut demand for safety and favored riskier currencies, as central banks were seen easing monetary policy, while employment figures from the US on Friday will give more hints on future Fed policy.
The European Central Bank is widely expected to cut rates in its policy meeting next Thursday to help curb the sovereign debt crisis. China may also decide to cut its rate at the next meeting, with a state-owned newspaper saying that the time was right for a cut of the banks’ reserve-requirement ratios (RRR). Last month, the Federal Reserve extended their “Operation Twist” program till the end of the year, but many market analysts now believe that continued weakness will push the US central bank to embark on another round of quantitative easing. The US jobs report on Friday will be a perfect gauge for the Fed ahead of their FOMC meeting at the end of this month, and a declining non-farm payrolls figure may well prompt policymakers to embark on a fresh round of stimulus.
The Reserve Bank of Australia kept its cash rate unchanged at 3.50 percent on Tuesday, in line with consensus. Forex investors had a limited reaction to the announcement. AUD/USD initially dipped from its session high of 1.0284 to 1.0257, but soon recovered to trade close to its day’s high. Gold found support on the renewed expectations for more Fed easing. Gold usually benefits as a hedge against rising prices as ample money supply and low interest rates sow the seeds of future inflation. XAU/USD was up more than 0.80 percent on Tuesday, to $1’612.60.
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