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EURO PLUNGING: EUR=1.2234 USD
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[link to www.howestreet.com]
Crisis of Confidence Hits European Financial Markets
What began as a debt crisis in Europe has become a prolonged rout in equity and commodity markets, with ripples spreading throughout the entire global economy. The calming effect of last week's rescue package is fading even more quickly than many had expected, with interest rate spreads widening and illiquid conditions beginning to afflict markets far beyond European shores. Conditions worsened over the weekend, and fear is ruling the financial markets once again.
The Euro fell dramatically over the last trading cycle, down to 1.2234 against the US dollar as investors expressed profound pessimism about short term liquidity and long term economic prospects in the European Union. The common currency is now trading well below the nadir set during the 2008 financial crisis.
For investors and traders in Euro-denominated assets, the rescue package has turned the investment environment negative in many ways. Firstly, the politically independent role of the ECB has been thrown into doubt. The Bank's mandate has always been inflation fighting, and has been shifted toward achieving economic growth, much like the US Federal Reserve. This change has caught many European investors unaware who were previously confident that inflation would remain low and stable over the long term. Most analysts expect that quantitative easing measures will be introduced in some form, diluting investment values and potentially raising inflationary pressures.
Austerity measures are also worrying financial markets. As governments try to trim expenses and reduce debt exposures, they will necessarily impact domestic growth patterns, potentially forcing economic activity downward. This may impact world trade by lowering consumption across the European Union, and thus reducing demand for products made in the Asian economies.
The sheer scale of the loan guarantees and debt purchases considered under the terms of the package will also weigh down government balance sheets for years to come, dampening growth and raising the possibility of future defaults.
Under the rescue package’s terms, the combined efforts of the European Central Bank, the International Monetary Fund, and European Union members are targeted at specific asset classes. This is allowing speculators to probe for areas of weakness in search of profitable opportunities where public money is not being used to support asset prices. Even for assets more broadly traded, last week’s rescue package is perceived as a temporary fix, with a fundamental restructuring of European debt obligations expected to eventually occur.
According to a survey conducted by FT/Harris in late April, 53% percent of the French, 46% of Americans, and 33% of British citizens feel that their governments are likely to default on their obligations within the next decade. History suggests that governments rarely default on their debts because they simply cannot pay. In general, governments default because the political gains outweigh the costs. As voters become more comfortable with the prospect, investors are becoming justifiably wary.
Throwing ever more debt at debt crises has been the default response of governments and voters across the developed world for a generation. Financial markets are finally expressing a lack of appetite.
Assets Markets Lose Steam
Diminished risk tolerance around the world is hammering the commodities complex down, with traders expecting the European crisis to lower growth globally. Front month crude oil has fallen precipitously, currently trading just above $71 a barrel after briefly dipping below the $70 mark in overnight trading. Most agricultural commodities have lost ground as well, reflecting fears of lower demand in the coming months, with wheat and soybeans leading the way down. Gold, traditionally a safe haven in times of trouble, has rather surprisingly fallen since last weeks’ peak, down to $1,225.
The Shanghai stock index which proved to be a strong leading indicator prior to the 2008 financial crisis, fell by more than 5% overnight. Most European and US indexes also dropped as yields rose, and the rising US dollar impacted growth scenarios.
Traders questioning the sustainability of last year’s liquidity-driven rallies are closing out positions and rebalancing portfolios as the world economy enters the next phase. With interest rates rising and little new liquidity entering the financial system, investors are valuing familiarity and security over the pursuit of yield.
Canadian Dollar Falls
The Canadian dollar followed commodity prices down over the weekend, falling past the 1.0400 mark at one point before gaining slightly this morning. Volatility in the USD/CAD currency pair has been elevated for weeks, with trading ranges much larger than normal.
To an extent, the Canadian dollar is simply falling because the US dollar is rising. However, doubts are quickly rising about the Bank of Canada’s willingness to raise rates in such an uncertain global environment (although most analysts still expect it to do so). Trading over the last few weeks has underscored the Canadian dollar’s unbalanced relationship with commodity prices. While most data is pointing to growth in the real economy, the Canadian dollar is falling in sync with commodity prices. This is a reversal of the pattern seen over much of the last year as commodity prices rose, while the economy struggled. Whether this dynamic will remain in place going forward remains an open question – but one that the market is waiting to answer.
Have a great week!
By Karl Schamotta, Market Analyst
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