EUR: Positioning its feet for a step in the right direction?

“After a storm comes a calm” - Matthew Henry

After the extreme gyrations of the end of last week, inspired by the Federal Open Market Committee, European Central Bank and US employment report, this week has begun on a more reflective basis. There are a number of important dynamics that have lead to some significant position squaring and as I suggested on Friday the ‘potential’ impact of the measures announced by ECB Chairman Mario Draghi (should the details not disappoint) can pave the way for a further correction in the EUR. My bias remains for further EUR gains in the near term. The longer term is a different question altogether as the troubles of the Eurozone are far from over but Draghi appears to have positioned his feet for a step in the right direction.

What price a Spanish bailout…?
It seems that the question of a Spanish bailout is no longer a simple answer for the newly elected, majority Spanish government. Last week's confirmation of the intent of Draghi to provide “whatever it takes” to ensure the preservation of the EUR has in some ways backed Spanish PM Mariano Rojoy into a corner. It appears that the only barrier to Spain entering the infamous group of bailout or programme countries at this point is the cost attached; the ‘modalities’ of seniority and bailout terms, that Draghi has promised in coming weeks.

It is not all bad for Spain, however. The pledge from Mario Draghi that the ECB would target the short end of the curve in order to maintain the ‘transmission mechanism' for monetary policy has seen Spain’s cost of borrowing for two years fall from almost 7 percent at the end of July to around 3.25 percent. Longer yields have also maintained their falls as the implied backstop from the ECB should the situation deteriorate (thus sharply increasing the probability of an imminent bailout request from Spain) provide an element of comfort to the market. To a certain degree, the market has already priced in a Spanish bailout, or at the very least has priced out the ‘tail risk’ of Spain being cut off from the financial markets!

On a slightly broader note Mario Draghi has conducted a very shrewd job of bypassing the ideological and constitutional objections of the German contingent of the Eurozone via his unrelenting focus on the ‘transmission mechanism’, sidestepping the ‘no-bailout’ clause of the Maastricht treaty with broad support from what appears to be the rest of the region (it must at least feel like this from Ms Merkel’s viewpoint).

Neutral RBA
Overnight the Reserve Bank of Australia (RBA) left rates unchanged at 3.50 percent and its analysis of the global backdrop could be seen as a further short term positive for risk assets with a more positive view of the current Chinese growth trajectory (despite the ‘consensus’ assertion that the global economic outlook is more subdued than a few months ago). Overall the statement was fairly neutral and the marginal easing bias remains. In the current dynamic, however, this should be enough to maintain further (if unspectacular) AUD gains.

Easing EUR sales?
Elsewhere the Swiss National Bank (SNB) published its July FX reserve data this morning, which suggest that reserve growth slowed to around CHF30B for the month, which may, at the margin, ease some of the selling pressure on other (not CHF) EUR crosses in order to maintain their reserve diversification.

In the UK, GBP has been on the back foot in recent trading sessions, despite a broader sell off in the USD keeping GBPUSD range-bound. The pressure on Standard Chartered will not help UK banking sentiment, but selling should remain isolated. With UK industrial production data this morning, the risks are perhaps for further GBP underperformance which should be most visible in EURGBP as it pressures recent highs. EURGBP will resume its downtrend at some point as I see things but for now a further correction is likely as the position squaring and risk on ‘relief rally’ continues.

Risk on?
On the day, a break below 6.58 percent in Spanish 10 year (Bono) yields and or a break above 1400 in the S&P will further boost risk sentiment and EURUSD above 1.2450 will likely be enough to make even the most ardent EUR bears reconsider their positioning in the short term.