EU Summit exceeds expectation, but UK services slowdown expected by Richard Driver of Caxton FX on 03-Jul-2012

Market confidence in the build-up to last week’s EU Summit was pretty much at rock bottom. Angela Merkel’s continued tough stance on eurobonds seemed to indicate a wider deadlock between Germany on one side and struggling eurozone nations such as France, Spain and Italy on the other.

In the early hours of Friday morning, EU chief Herman Van Rompuy announced several decisions which gave risk appetite and market sentiment a major boost. Two key questions left by the Spanish bank bailout deal were answered. First, the bailout funds will be able to directly recapitalize Spain’s banks, without adding to the debt-to-GDP ratio of Spain as a whole and forcing its borrowing costs up. Second, the bailout loans will not be given senior creditor status, easing concerns that private bondholders will not see their investments completely written off. In addition, pledges were made that the bailout funds will be able to invest in distressed bonds directly, again relieving concerns around the Italian and Spanish bond markets.

Clearly, the markets were impressed by these decisions and they certainly buy some more time, but they don’t amount to a silver bullet solution to the debt crisis by any stretch of the imagination. We still lack any detail on the fundamental issue of longer-term fiscal union and whilst the bailout resources can be used more flexibly now, though its size remains inadequate.

ECB and BoE both set to make moves this week

ECB Chief Economist Peter Praet stated recently that "there is no doctrine that interest rates cannot fall below 1 percent". Comments such as these lead us to believe that the ECB is set to cut its already record-low 1.00% interest rate to 0.75%. There is a significant risk that the ECB will cut rates to 0.50%, in light of weak eurozone growth data and fading inflationary risks. Whilst the market is likely to be grateful that the ECB is taking action, the reduction in the euro’s interest rate differential is likely to be a negative for the single currency in the longer-term.

We expect the Bank of England to introduce further quantitative easing on Thursday, in light of the distinctly dovish tone within last month’s MPC minutes and the four votes in favour of QE that they revealed. Only one more dovish voter is required for a majority in favour of QE and we believe this will come on Thursday. The move looks to be fully priced in though, so sterling has already taken the pain in relation to this move. Wednesday’s UK services figure will be watched closely on Wednesday, a slowdown is expected.

End of week forecast
GBP / EUR	1.2550
GBP / USD	1.54
EUR / USD	1.2475
GBP / AUD	1.57

The dollar has suffered a significant sell-off amid booming risk appetite in the aftermath of the EU Summit. We maintain a bullish outlook for the US dollar moving forward, although the week ahead brings with it significant risks. Friday’s US non-farm payroll is expected to show a mild improvement, but amid the softness in US growth data of late it would be no surprise to see the result undershoot expectations.

The euro’s rally has already run out of steam; GBP / EUR is trading up above &euor;1.2450 and EUR / USD’s has pared back from $1.27 to below $1.26. We continue to target levels well above €1.25 for sterling. A further decline in the EUR / USD pair will surely weigh on GBP / USD, which is coming up against stiff resistance around $1.57.

Richard Driver is a Currency Market Analyst with Caxton FX and can be contacted via: www.caxtonfx.com

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