Rating agencies and Germany break the Eurozone peace

Two developments last night and this morning have triggered a wave of euro selling. The first was Moody’s downgrade of Portugal’s credit rating to junk status, and the second was news that Germany was planning to revive a plan for Greek bondholders to swap their debt for securities with longer maturities. Germany’s original plan was opposed by the European Central Bank (ECB) because it would mean more onerous terms for private investors compared with France’s rollover plan.

Europe’s biggest banks are meeting in Paris today to discuss private sector participation in a second bailout of Greece and the news from Germany is concerning on two fronts. Firstly, the ECB was against Germany’s original proposal so it may be a summer of wrangling between the various branches of the European authorities on how to structure a second rescue package for Athens, which is likely to weigh on investor’s appetite for risk going forward.

Secondly, it suggests that Europe is getting more comfortable with triggering a default event for Greece in a bid to get the private sector to shoulder some of the burden of a second bailout. However, it is not a given that the markets will be so sanguine.

We are at a critical stage for the Eurozone, the euro has come under pressure today, the dollar is higher and dollar index is above its 50-day moving average. Dollar strength is weighing on stocks and commodities, and the Vix index, Wall Street’s fear gauge, is likely to jump when the US opens. So last week’s respite for risky assets may prove to be short-lived.

What is worrying is the frequency of flare-ups in the Eurozone’s peripheral crisis. Last week was the Greek austerity vote, today its Portugal and there are rumours that Ireland will also be downgraded, currently Standard & Poor’s rate its debt at BBB+. It is hard to see how investors will maintain their appetite for risk with the situation in Europe lurching from one crisis to the next. So it could be a rough few months ahead.

The performance of the single currency is more difficult to predict. While we think it may remain supported versus the dollar, it may come under pressure against the Swiss franc. In such volatile markets it is hard to see much upside for this pair and we expect EUR/CHF, and most of the CHF crosses to continue to do well.

The sterling rally that was triggered by a surprise increase in the services sector PMI yesterday has reversed today as risk appetite has taken a dive. Data out of the UK overnight was mixed. The British Retail Consortium shop price index was higher, rising to 2.9 per cent in June from 2.3 per cent in May. This is bad news for the Bank of England as inflation pressures are rising at the same time as growth is lower. However, it is good news for retailers who may be able to boost their margins if they can pass through higher prices to consumers.

House prices were also stronger, raising 1.2 per cent in June according to Halifax. We are not constructive on the pound and although we don’t think the Bank of England will change rates or make an announcement of further quantitative easing at tomorrow’s meeting, it’s not out of the question in the medium-term.

Elsewhere, economic data out of Europe continues to show the core economies doing well. Factory orders in Germany rose by 1.8 per cent in May; the market had been looking for a 0.5 per cent fall, boosting the annual rate to 1.2 per cent. This led to a momentary respite for the euro; however, we think peripheral concerns could trump growth indicators today.

Kathleen Brooks is research director at Forex.com

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