Eurozone downgrades -- desperate, but not serious

Important shifts in EU/ECB attitudes

The credit rating downgrades did not occur in a vacuum, and there were other important developments this past week that also suggest some potential for a EUR respite. The ECB held rates steady and indicated it saw tentative signs of stabilization in the Eurozone downturn, though it’s also prepared to act if conditions deteriorate. This suggests the ECB is in wait-and-see mode, eliminating imminent rate cuts as a EUR-negative. Indeed, spreads between German/US 2-year government yields have bottomed and moved slightly higher, suggesting EUR/USD should be above 1.2800.

In addition to the ECB’s LTRO, which has seen stresses in the European banking sector recede, the ECB is apparently considering accepting banks’ loan portfolios as eligible collateral for borrowing from the ECB, potentially making nearly EUR 1 trillion in additional ECB lending available. And another LTRO is slated for February, reinforcing the idea that EU bank financing pressures will further fade. Lastly, German Chancellor Merkel appears to have blinked as she indicated this past week that Germany could increase its capital contribution to the IMF, if others chose to follow suit. This movement should not be underestimated as it indicates that Germany is in fact prepared to do more, though certainly within limits. All told, conditions appear to be stabilizing in EU banking circles and government debt markets as opposed to worsening, suggesting greater potential for EUR stabilization at the minimum. Add on excessive EUR short-positioning and we think there’s potential for a correction higher.

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