Euro Surges on Developments from Euro-zone Summit
THE TAKEAWAY: [EU Leaders Release Details on Restoring Confidence] > [Instills Hope for Minimum Collateral Damage Stemming from Greek Default] > [EURUSD Bullish]
Markets were placed in a dicey situation earlier in the trading day in New York after it was leaked that Euro-zone leaders had yet to reach an agreement on how to handle a Greek default. Risk-appetite was steadily tailing off after European markets closed, and the major currencies were contained in tight 25-pip ranges versus the U.S. Dollar in anticipation of the scheduled 20:00 GMT news conference in Brussels by various Euro-zone leaders.
EUR/USD 5-minute Chart: October 26, 2011
Charts created using Strategy Trader– Prepared by Christopher Vecchio
Higher yielding and risk-correlated assets, including the Australian Dollar and Euro, were bid higher after Euro-zone leaders released a joint statement highlighting the progress made during meetings that occurred that past few days. The EUR/USD jumped nearly 100-pips after the statement was released, while U.S. equity markets surged back towards daily highs.
The statement noted some following key points that need to be addressed “urgently”:
- The need to ensure the medium-term funding of banks, in order to avoid a credit crunch and to safeguard the flow of credit to the real economy, and to coordinate measures to achieve this.
- The need to enhance the quality and quantity of capital of banks to withstand shocks and to demonstrate this enhancement in a reliable and harmonized way.
- A simple repetition of the 2008 experience with full national discretion in the setting-up of liquidity schemes may not provide a satisfactory solution under current market conditions.
The statement also discussed the keystone issue – what recapitalization efforts will look like:
- There is broad agreement on requiring a significantly higher capital ratio of 9 percent of the highest quality capital and after accounting for market valuation of sovereign debt exposures, both as of 30 September 2011, to create a temporary buffer, which is justified by the exceptional circumstances.
- This quantitative capital target will have to be attained by 30 June 2012, based on plans agreed with national supervisors and coordinated by EBA. This prudent valuation would not affect the relevant financial reporting rules.
The points discussed in the statement were well-known for some time, and it is to be expected that further steps will be taken. For one, government leaders are discussing ways to leverage up the European Financial Stability Facility; according to a report issued by Reuters and later confirmed by CNBC, it appears that up to four-times leverage will be employed. Whether or not that is enough capital to cover losses incurred by a Greek default or other losses resulting from the effects of contagion will be revealed in the coming weeks and months.
It is worth noting the ramifications of the new 9 percent Tier 1 Capital Ratio rule that will be in place eight-months from now. To start, after American banking institutions received liquidity injections in November 2008, equity markets plummeted for five-months thereafter before bottoming in March 2009. An eight-month window appears to be too lenient, as a Greek default is looming on the horizon. Likewise, where European banks currently stand, a 9 percent ratio would leave 65 banks with insufficient capital, before a Greek write-down of any amount is factored into the equation. Circling back to the previous paragraph, it appears Euro-zone leaders are thus hoping that a leveraged EFSF will be enough to cover the capital shortfall.
Looking ahead, it is likely that the higher yielding currencies and risk-correlated assets will find bids higher on news of relief to credit markets. If a liquidity crunch is ruled out in the short-term, then the U.S. Dollar is likely to come under pressure as investors flee safer assets and shift capital into riskier investments, knowing full-well that their investments are back-stopped by Euro-zone measures. In the medium-term, the mix of introducing further austerity to the periphery nations coupled with further easing and additional bank bailouts could provoke additional civil unrest, a scenario desired to be avoided as the protests against said measures have already taken a turn for the worst. Should public outcry move beyond protests in the periphery to the core, the future of the Euro-zone, and the Euro, will be at stake.
--- Written by Christopher Vecchio, Currency Analyst
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