Madrid’s auction success comes at a price
 
After yesterday’s rout in the markets investors are taking a breather. This has helped the euro to stage a rebound, although it is running into resistance at 1.4220. Likewise, Italian and Spanish bond yields are also lower after reaching fresh euro-era highs yesterday.

Helping to sooth the mood in the markets was a 'successful' Spanish bond auction. Madrid sold €4.45 billion of 12 and 18-month notes and demand was strong; the 12-month auction had a bid-to-cover ratio of 2.18 times, the 18-month auction was even more popular at 5.49 times.

But Spain had to pay a high price to entice investors to purchase their debt. The yield on 12-month debt rose to 3.7 per cent from 2.7 per cent in June, and for 18-month debt the yield surged to 3.9 per cent from 3.2 per cent in June. These rates are not sustainable. The big test for Spain comes on Thursday when it is scheduled to auction 10 and 15-year debt. With 10-year bond yields already above 6 per cent, markets will be watching for: one, a healthy bid to cover ratio; and two, the yield investors charge to hold the debt.

Spain’s debt auction coincides with the latest EU summit that is turning into crunch time for the currency bloc. If there isn’t a credible solution to the Greek bailout, a final decision on private sector involvement and possible steps towards fiscal union then Spain could find it harder to sell its debt at a reasonable yield. Spain can’t rely on support from the European Central Bank (ECB) on Thursday; the latest data from the bank suggests that it continues to stay out of the market and won’t buy up bonds to support debt auctions of member nations.

Whereas in the past investors have been tolerant of indecision by the upper echelons of power at the EU, this time markets’ are pressuring the EU to take action. If they don’t then we should expect Italian and Spanish bond yields to blow out, pressure on French and Belgian yields to increase, German bund yields to drop and other safe havens to surge; it may also drag EUR/USD below 1.4000.

Right now the euro is rallying. This is partly a pullback after yesterday’s major rout in European credit and equity markets, and it is also a reaction to a surprisingly strong reading for the German investor confidence survey the ZEW. This current situation component rose to 90.6 from 87.6 in June, close to its recent peak. This has helped push EUR/USD above 1.4200.

However, there are clouds gathering on the horizon. The economic sentiment indicator fell more than forecast to -15.1 from -9.0 in June. This survey has been affected by the escalating sovereign debt crisis and the recent falls in the stock market. The escalation of problems in Italy probably contributed the most to the major dip in this index. The outcome of this Thursday’s EU summit will be pivotal to investor confidence for the rest of this year in our opinion. The markets will be looking to draw a line under the current crisis this week, and if the EU fails to deliver the goods they will be punished by a sell-off of euro-based assets in our opinion.

In the absence of much economic data the markets are reacting to headlines. The ECB has been on the airwaves in droves to reiterate its stance against any sort of default for Greece. Germany has come out and said it intends to 'send a clear signal' to markets at the EU summit. Details are scant at this stage, but there is a long way to go before a satisfactory resolution is found.

Elsewhere, the Reserve Bank of Australia minutes from its meeting earlier this month showed a shift to a more neutral policy stance. Interest rate expectations continue to recede for Australia and some in the markets are looking for rate cuts in 2012. The Aussie remains stuck in a range, and is moving in line with general risk appetite.

The Bank of Canada announces its policy decision at 1400 BST today. It is expected to keep rates on hold at 1%. There are some concerns that the Bank of Canada is falling behind the curve, however, the Bank will be worried about raising rates when the Fed is staunchly on hold.

The mood in the markets has calmed significantly, the euro has clawed back some gains against the Swiss franc, and however investors are still wary and are not willing to push EUR/CHF back up above 1.1800, considered a key resistance level.

Gold remains above $1,6000 per ounce, and the gold/silver ratio continues to show silver outpacing gains in gold after lagging the yellow metal in recent months.

Kathleen Brooks is research director at Forex.com

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