Summit risks

The buoyancy of EUR/USD since the middle of the month illustrates that investors are for the present content to maintain a ‘glass half full’ approach to the Sovereign Debt crisis.  For the past 10 days or so asset values have felt no significant negative impact from the lack of a deal between the Greek government and its private sector creditors on the amount of the haircuts the latter will ‘voluntary’ suffer. 

Since Greece’s second bailout plan cannot be signed off without the PSI agreement in place it is fair to say that at most points over the past two years the market would have reacted with a lot more despair than it can currently muster.  At present the mantra that “a deal is imminent” has been sufficient to buy the market’s patience.

The better tone of the EUR and the easing in Italian and Spanish bond yields are related to the success of the ECB’s ability to sooth the flames of the crisis with huge amounts of liquidity.  The ECB cannot solve the crisis, however.  This is the job of Eurozone politicians. 

Conversely the success of today’s leaders’ summit in Brussels could be hampered by the better tone in markets.  Chancellor Merkel continues to resist calls to increase the size of the ESM’s firewall.  Without an increase it is less likely that non-European countries will have a will to pump more funds into an IMF firewall.  Merkel, however, must answer to her electorate and with Italian bond yields off their peak it is less likely that she can make the case for additional German contributions.  Merkel also hopes to strengthen the proposal for a fiscal pact for the Eurozone today.  Most commentators agree that some form of fiscal union is a necessary part of a solution for the crisis.  The idea of a fiscal pact is built around the idea that budget controls in the region need to be tightened.  If this can be done than the Eurozone will be on its way to implementing a solution for its fiscal ills.  However, over the weekend reports have emerged that Greece is strongly objecting to hand over the reins of its fiscal policy.  This reaction is understandable from a sovereign nation, but it does highlight the difficulties of policing tough budget controls.  

Against this backdrop there are risks that today’s summit will disappoint.  The EUR may continue to draw solace from the ECB’s liquidity rush on the assumption that this supports today’s Italian debt auction.  However, a poor result from Brussels today will heighten our fear that downside pressure will re-emerge in the EUR.  We continue to see risk that EUR/USD will push lower towards 1.2500 on a 3 mth view.  Support lies at EUR/USD1.3075.  
 
CFTC data show that EUR shorts moved even further into record territory as at Jan 24.  The better tone of EUR/USD during the week suggests that some of these shorts were likely covered.  Even so the extent of these shorts and the coincident increase in USD longs on Jan 24 provides strong evidence that the market remains very wary of Eurozone headwinds.  The continued build in AUD longs and the improvement in GBP and CAD suggests that EUR diversification trades remain very topical.  
 

source: Rabobank