Euro weaker on debt unrest

(09.03.2011) Debt unrest weakened the euro yesterday, while a correction in the oil price improved the investors' mood and pulled the stock market and long government bond yields up.

By Kjersti Haugland, Analyst at DNB Markets

euro coinThe euro is being pulled between two conflicting market themes at the moment. Unrest surrounding debt-ridden euro zone members is a weakening force, while expectations regarding a approaching hike from ECB in the wake of Trichet's press conference last week is a strengthening force. Debt unrest dominated yesterday, and the euro weakened. After Moodys downgrading of Greece on Monday the euro has come down from 2011's highest quotation, 1.40, to right below 1.39. During yesterday's session, 10-year yield on Greek government bonds reached the highest level in the euro's history - almost 13%.

Last summer the Committee of European Banking Supervisors (CEBS) succeeded in calming the market's euro nerves, when publishing the results of a stress test performed on 91 European banks. None of the large, systemically important banks were even close to failing the test, while the seven banks which did (five Spanish, one German and one Greek) were small and only had 1.5% of European banks' balances. Critical voices argued that the test had been too soft on the banks. The failure of Irish banks by end-2010, banks that passed the test earlier that year, was indeed a sign that a positive result was far from a guarantee of survival.

A new stress test is due in March and April, and European officials have assured that it will be tougher than the last one. The newly established European Banking Authority will be in charge, and the credibility of the fresh institution is highly dependent on tests being modelled in a way that spurs confidence among the agents in the market. Reuters had gotten hold of the documents that sketched out the new scenarios yesterday. The macro shocks seem very similar to the shocks in the previous test, involving a 0.5% decline in euro zone GDP in 2011 as well as a 15% decline in the value of stocks. For the first time it also involves a 75 basis point increase in euro zone long government bond yields, combined with a marked fall in the real estate market. The test will also involve a negative global demand shock originating in the US, as well as a marked weakening (4%) of the USD.

US Finance Minister Timothy Geithner visited Germany yesterday to engage in talks with his German colleague Schäuble. Germany is reluctant in agreeing to ease conditions of Greek and Irish rescue packages, and in giving the European rescue fund more power. EU summits on Friday and in the end of this month will be followed closely by the market, which expects (or hopes) to see signs that the parties are reaching some sort of an agreement. Geithner's visit is a signal that the US is worried about the negative impact of new European unrest on the fragile US upturn.

Other developments since yesterday morning: International stock markets rose and US and European government bond yields pulled up when investors were encouraged by a drop in the oil price. The correction came after Kuwait authorities signalled a possible increase in OPEC production quotas to make up for lost Libyan oil supply. Asian stock markets have also been lifted by better-than-expected machine orders in Japan. Yesterday's solid German manufacturing orders impliy that the impressive German upturn continues. Today's production numbers from Germany will probably confirm this impression.

Speculations regarding who will be first mover, ECB or BoE, in hiking rate as a response to high headline inflation, continue. The board of the latter gathers today, and the decision is announced tomorrow. At the previous meeting the committee turned more aggressive. The hawk Sentance voted to hike by 50 basis points, and both Weale and Dale wanted a 25 basis point hike. The dove Posen held on to his wish to increase asset purchases. We expect the interest rate to be unchanged at this meeting. Only 1 out of 63 respondents expects a hike at this meeting, according to Reuters. We expect BoE to hike in May, while we expect ECB to hike already in April.