Europe, ECB make a step forwards

Judging from the reaction on financial markets, both ECB and the European politicians failed. Yet when you look at the details it seems like they are actually moving things in the right direction:

• The ECB not only cut rates for the second straight month but also extended maturities and acceptable collateral for loans it offered to banks
• At least 23 countries (and possibly 25 with all euro area countries) will agree on the new fiscal compact that will force automatic sanctions against countries with an excessive deficit

Governments and central banks will channel 200 bln EUR through the IMF to any countries that need a support and the ESM will start functioning in the mid ’12 (replacing EFSF) with 500 bln EUR of capacity

Obviously we do not have treaty changes (notably due to a resistance from the Brits) and we do not have direct ECB lending (via ESM which will not gain a banking license) so there was no positive surprise but those things were far from sure anyway (actually an obstructions from the Brits was certain). Thus as long as those conclusions are implemented swiftly and smoothly, Europe might avoid further significant deterioration on the bond markets, which now seems to be a key factor for both the EURUSD and the equity markets.

EURUSD, equity markets – lost chances

At the beginning of the week we pointed at a yawning divergence between equity markets and the EURUSD. There was a chance that the EURUSD could “catch up” to equity markets. The argument was that the rally on bond markets in (ex-Germany euro zone) Europe was so strong that unless politicians spoiled things, the euro could have gained despite a cut in interest rate.

The politicians not necessarily spoiled things but they didn’t take advantage of the momentum offered by the markets. In fact, even before the summit begun the course on the bond markets reversed amid signs that the ECB will not increase the bond buying program but also that some countries were not ready to back the deal. Agreements reached today (look above) are definitely moving Europe in the right direction but since markets want things solved here and now, we are far from euphoria. Consequently, the divergence we mentioned is being closed not by the EURUSD moving up but by equity markets giving up their previous gains.

In the longer horizon, equities are still to receive a signal from the global economy: developments in the US are encouraging, in Europe are worrying and in Asia are mixed. Thus it seems to be crucial for Asia to avoid a significant slowdown.

Przemysław Kwiecień PhD, Chief Economist

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