Morning Brief – Hats off, Masks on

Hats off, Masks on

In March this year, the pandemic unmasked the fragility of European risk sharing (pardon the pun). Not only did the Union not have adequate risk sharing procedures in place on the fiscal and monetary front but it also felt like every man for himself. Cross border state aid and the provision of PPE in Italy, for example, saw geopolitical tensions rise between the Union and Russia. In financial markets, the cost of borrowing money in Italy, Spain and Greece jumped above more developed Eurozone members, Germany and France. Since March things have changed, an initiative towards a European Recovery Fund has advanced, the ECB’s emergency measures have cooled markets and the Euro has rallied accordingly to trade 6.5% and 1.2% stronger versus the Pound and US Dollar respectively since the start of the year.

For the first time in the four months of the European pandemic outbreak, borrowing conditions in the Eurozone have normalised. The cost of borrowing money amongst more indebted European nations including Italy, Spain and Greece has fallen back to pre-crisis levels. The differences in bond yields amongst these nations is critical for European financial health. It is a leading indicator of European risk conditions and if differentials are too pronounced can directly generate dynamics that undermine the currency union. The normalisation of the difference in the cost of borrowing across the Eurozone is testament to the ECB’s emergency action and monetary response to the crisis to the tune of €1.35tn – a fairly hefty price tag for a few basis points in yield. It is also worth noting that investors’ hunt for yield has also forced them to buy peripheral European debt aiding the ECB’s efforts.

This week sees both the latest European Central Bank meeting (Thursday) and the latest EU summit (Friday & Saturday) where leaders will meet to discuss the European Recovery Fund. Chancellor Angela Merkel confirmed yesterday that further progress had been made behind the scenes with Italy and Germany supposedly having agreed on the basic structure of the recovery fund. As two proponents of the Fund, markets did not receive the news with immense surprise with the Euro largely unchanged. The Euro is on the front foot this week taking the lead from a weaker US Dollar that, in the absence of salient data releases yesterday, is finding its direction determined by risk conditions and in particular stock market performance. With cases still climbing in the US and records being set over the weekend for daily infections in the so-called sunbelt states, US domestic risk could also begin to undermine USD dynamics.

Discussion and Analysis by Charles Porter

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