European problems get more complicated

The dollar has been the big mover of the European session so far. The greenback is higher versus the euro, the pound and the Swiss franc. The last line of defence has been the yen; however, even USD/JPY looks like it has made a base around 76.65. It’s difficult to pin point the exact cause, although it is most likely due to positioning. After yesterday’s big rally, the European stocks are flat to lower this morning as risk appetite take a breather. The UKX 100 is the outlier. It is higher today, but it is most likely playing catch-up since the UK market was closed for a public holiday at the start of the week.

News out of Europe today has been fairly mixed. On the downside, the International Accounting Standards Board (IASB) said that some of the write-downs being performed on Greek debt by the banking sector are not in line with accounting rules and are a 'matter of great concern'. This may have dented sentiment, especially towards the financial sector. The Eurostoxx 50 is down 0.4 per cent so far today, dragged lower by financials and utilities. The euro tends to move with risk, so as stocks fall, so too does EUR/USD.

However, to balance this Italy held a successful debt auction, and the yields on ten-year debt actually fell relative to its last auction at the end of July. Investors bought the allotted €3.75 billion of Italian securities and yields declined to 5.22 per cent. This was a key litmus test for the third largest economy in the Eurozone. The European Central Bank has been buying Italian and Spanish debt in the secondary markets for the past three weeks to try and stabilise bond yields, however the central bank can’t directly participate in debt auctions so Italy was all alone this morning. Yields on the secondary market spiked after the auction to a high of 5.16 per cent - more in line with the auction yield – although they have since started to moderate.

However, Europe still remains mired in trouble. Germany’s parliament announced this week that it had postponed by a week the vote on the legality of the expansion of the European Financial Stability Facility (EFSF) rescue fund – the Eurozone’s latest plan for dealing with its sovereign debt crisis. The vote will now take place on 29 September, after the Pope’s visit to Germany. So far several lawmakers have said they will vote against the extension. Although the EFSF changes are likely to be passed by Eurozone governments, dissent from Europe’s largest paymasters could rock sentiment as it would leave doubts about how committed Germany is to protecting the currency bloc.

Added to this, a Spanish Socialist Party spokesman said that tensions in the Spanish debt market may worsen in the autumn. Spain still has a hefty debt auction schedule, and has nearly €50 billion of debt to finance by the end of the year. This also coincides with a general election that is expected to be held in late November. Whether or not Spain finds it hard to auction its debt will depend on a couple of things: one, the German vote to pass the changes to the EFSF; and  two, the timely release of the next tranche of bailout funds to Greece to ward off an Athenian default.

The release of the next tranche of bailout funds for Greece is not a done deal due to the on-going collateral issues. Today it was announced that Eurozone finance ministers who meet next week would discuss the issue. However, it continues to split the currency bloc. A senior German Politician and ally of chancellor Angela Merkel said it was 'fatal' to demand collateral for EFSF aid in a speech today, and that Germany will be talking to Finland about its collateral demands. This wrangling threatens to cause panic in the markets in the next few weeks, and any deterioration in the talks to resolve this issue is a potential risk-off event.

Economic data in the UK and Europe hasn’t been a major market mover today. In the UK money supply contacted for a tenth successive month; and Eurozone confidence slipped in August. Ahead today the minutes of the Federal Reserve’s Federal Open Market Committee meeting will be scrutinised by the market as investors try to determine if more quantitative easing (QE) is waiting in the wings. At the last meeting there were three dissenters who did not agree that interest rates should remain low until at least mid-2013.

Persuading these members will be key before any more policy stimulus is announced. The economic data remains broadly weak, however inflation is ticking up so the Fed will need to be careful how it performs more QE. One possibility is QE-Lite, whereby the Fed continues to purchase Treasuries at longer maturities – thus depressing yields further out the curve - while selling shorter-dated maturities causing yields to rise and sucking excess (inflationary) liquidity from the economy.

Fed dissenter Narayana Kocherlakota is speaking today at 1715BST. This speech will be used to determine if he can be persuaded to vote for more QE next month. So this may cause some volatility in the markets later today. The Fed’s September meeting is gearing up to be the most important of the year.

Kathleen Brooks is research director at Forex.com

To receive more relevant articles like this one, why not sign up to our weekly newsletters, click here