EU Summit Outcome Sinks Dollar, Threatens Long-Term Euro Outlook

Talking Points

• Market-wide Confidence on the Upswing, Threatening US Dollar
• EU Summit Outcome Lifts Risk Appetite Along with the Euro
• Plans for Euro Zone Stabilization to Hinder Growth, Rate Hikes

Sentiment is on the upswing after yesterday’s EU leaders’ summit outlined a powerful bailout for Greece, effectively meeting the country’s funding needs for the foreseeable future (contingent on its ability to meet austerity requirements). S&P 500 stock index futures – a proxy for risk appetite at large – are firmly in positive territory in late overnight trade, pointing to losses for the safe-haven US Dollar and Swiss Franc as well as the Japanese Yen as chipper investors reinstate carry trades funded in the perennially low-yielding currency. The German IFO Survey of business confidence headlines the economic calendar and is expected to show sentiment soured for the fifth consecutive month, but the outcome is unlikely to garner much attention amid broader market-wide relief in the now apparently more stable macro environment.

However, a deeper look at the implications of what the Brussels meeting produced points to long-term downward pressure on the Euro. In our pre-summit analysis, we discussed the need for EU leaders to go beyond Greece and reassure the markets with meaningful steps to cut off region-wide contagion of the debt crisis. At the surface level, policymakers did just that. Most critically, the powers of current EFSF bailout fund and the future European Stability Mechanism (ESM) were expanded, allowing them to:

1. Funnel money into EU banks, including those in countries not currently getting a bailout
2. Intervene in the open bond market to keep down ailing member states’ borrowing costs

To secure long-term stability – or at least give the impression of moving to do so – EU leaders pledged to offer Portugal and Ireland the same attractive lending rates secured for Greece (essentially consistent with a AAA-rated country) and admonished all member states not currently receiving bailouts to bring deficits below 3 percent of GDP by no later than 2013. Countries were also back-stop their domestic lenders in line with the latest round of stress tests (however flawed).

Crudely speaking, the deficit-reduction commitment of non-bailout countries (which account for 91.1 percent of overall Euro Zone growth) will halve their cumulative expected GDP growth rate to an average of about 1 percent through 2013. By contrast, the remainder of the G10 (excluding perennially anemic Japan) is expected to yield an average growth rate in excess of 2.6 percent.

This means that even without accounting for the potential cost of any future bailouts that would increase the burden of deficit-reduction efforts, the implied economic growth dynamics argue for ECB monetary policy that is substantially more dovish than most its major counterparts. Simply put, higher growth rates amount to stronger inflationary pressure, and the pronouncements of EU officials at yesterday’s summit effectively commit much of the Euro Zone to sub-par performance with little scope for rate hikes. Needless to say, this bodes ill for the single currency against the major currencies in the months ahead.

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

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