Euro Sell-Off Extended On Persistent Worry On Spain

Euro remained broadly pressured last week and fresh selling was seen towards the end on renewed concerns in Spain. Spanish 10-year yields closed above 7.2% and were a clear reflection on markets' lack of confidence despite all the efforts by European leaders. Risk appetite was originally solid on corporate earnings and sent the Dow to as high as 12977 and boosted the aussie, kiwi and loonie against dollar. The contrast in the sentiments could be seen with EUR/AUD and EUR/CAD dropping to new records. However, equities markets were then dragged down by eurozone worries and sent the high beta currencies lower. After all, the overall development in markets remained unchanged.

Equities could still try to make another high cautiously, on expectation on more easing from major central banks, even though the path would be bumpy. The aussie and to a lesser extent, the Canadian dollar and sterling, would benefit most from risk rallies while the euro will definitely lag behind. Eurozone concerns will be the major driver that set risks back and in those cases, the common currency would continue to be sold off. The dollar and yen would be stuck mixed with yen with an uncertain upper hand. So, selling EUR/AUD, EUR/CAD, EUR/NZD and to a lesser extent, EUR/GBP, would remain the strategy that has the clearest higher odds.

Some late developments in the eurozone should be noted. Spain said on Friday that the GDP will contract -0.5% in 2013, a sharp downward revision from prior projection of 0.2% growth. 2012 projection was revised slightly up from -1.7% to -1.5%. Nonetheless, the data means Spain will remain in recession at least till the end of 2013. Also, Valencia, Spain's most indebted region, sought help under the EUR 18b program passed on Thursday. The act reflected the fact that Spain's regions are suffering from a liquidity shortage in the markets and more are expected to come.

The negative news overshadowed the fact that eurozone finance ministers approved the terms of the EUR 100b bailout for Spanish banks. The Spanish 10-year yield closed at 7.267% and broke above June's high. It should be noted again that 7% is seen by markets as an unsustainable level that eventually led to national bailout of Greece, Ireland and Portugal. So situation in Spain is getting more dangerous now. Another negative news was that ECB said on Friday that it would reject Greek government bonds as collateral for its lending operations. And ECB said it would revisit the eligibility of Greek bonds only after the Troika conclude their reviews on Greece's progress in austerities and reforms.

Another development to note is that even since ECB cut the benchmark interest rates to historical low of 0.75% and deposit rate to 0.00% on July 5, Euribor continued to dive. The three month bank-to-bank lending rate dropped to a new record low of 0.451% on Friday. That's the first time it dropped below 3 months dollar LIBOR since 2008, which fixed at 0.451% on Friday. That's based on market expectation that more rate cuts could be seen from ECB ahead. Indeed, ECB Executive Board Member Coeure said that negative rates is an option.

In the US, Fed Chairman Bernanke's semiannual testimony was another disappointment. Bernanke noted that the US economy has continued to recover but "activity appears to have decelerated somewhat during the first half of this year." Also, he said that a fall in the unemployment rate would likely be "frustratingly slow." He described that recent data had a "generally disappointing tone" and warned that the so-called fiscal cliff could push US back into a "shallow recession" early next year.

He urged the Congress to "work to address the nation’s fiscal challenges in a way that takes into account both the need for long-run sustainability and the fragility of the recovery." Meanwhile, Bernanke also warned that possibility of worsening in Europe "remains a significant risk to the outlook." He pledged that the Fed is "prepared to take further action as appropriate to promote a stronger economic recovery," but fell short of hinting on what and when additional stimulus would be implemented.

BoE minutes for the July 4-5 meeting revealed that the MPC voted unanimously to keep rates unchanged at 0.5%. However, the vote for expanding the asset purchase program by GBP 50b was not unanimous but by 7-2. Spencer Dale and Ben Broadbent preferred to keep the size unchanged. Nonetheless, policy members felt that the case for additional stimulus was "compelling and stronger than at the previous meeting" as there were "increasing signs that the threat of a disorderly resolution of the financial tensions in the euro area was affecting growth at home."

The minutes noted that inflation has moderated faster than projected in May's quarterly inflation report due to "reduction in global energy prices." And "all members of the Committee judged that further economic stimulus was required in order to meet the inflation target in the medium-term." Meanwhile, the impact of the Funding for Lending Scheme and other policy initiatives might "alter the committee's assessment" of the effectiveness of further rate cut and would be reviewed. That is, rate cut is back on the radar in MPC's mind.

BoC kept rates unchanged at 1.00% as widely expected. The bank maintained tightening bias and said that "to the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate." However, the bank did lower growth forecast to 2.1% in 2012 and 2.3% in 2013, comparing to prior forecast of 2.4% for both years. Core inflation is expected to remain around 2% over the projection horizon while total CPI is expected to remain "noticeably below the 2 percent target" over the coming year before returning to target around mid 2013.

RBA minutes struck a less dovish tone and lowered the chance of another rate cut in August. RBA noted that "with a material easing in monetary policy having occurred over the preceding six months or so, and with recent signs that the domestic economy had a little more momentum than had earlier been indicated, members saw no need for any further adjustment to the cash rate at this meeting."

The IMF lowered the global growth forecast for 2012 and 2013 to 3.5% and 3.9%, down from prior projection of 3.5% and 4.1% respectively. IMF noted that the largest signal risk to global growth is "associated with a potential escalation of the crisis in Europe." It hailed the outcome of last month's EU summit as a step in the "right direction" but also urged that progress on banking and fiscal union must be a priority for political leaders. Also, The IMF warned that if the US could not deal with the so-called "fiscal cliff," there could be enormous shock to US as well as other advanced economies.

The IMF urged ECB to "provide further defences against an escalation of the crisis." It said in a report that the measures could include "policies to support demand in the short run and fend off downside risks to inflation, as well as measures to ensure that monetary transmission, currently impaired by financial stress in some countries." Also, the ECB should be give "explicit responsibility for financial stability," and "full lender-of-last-resort functions." The ECB could also cut rates from the current historical low of 0.75% plus "buy a representative portfolio of long-term government bonds."