EU emergency funds and the euro

During the weekend European leaders decided on an emergency fund to eradicate contagion fears and potential systematic risks that might follow the Greek debt episode. Finance ministers made their final preparations ahead of the Monday's open in Asia. The package comes out strongly and it shows the European Union's determination, so much so that it was referred to as the "shock and awe" rescue plan.

The package attempts to at least cure the symptoms. This package is a very significant step and it is supportive of the euro (at least in the short term) as it should eradicate contagion fears. The European Union will expand the stabilisation fund used for non-eurozone members by €60 billion and the funds will be made available to all eurozone members.

This increment will be financed through the issuance of bonds by the EU. In addition the 16 members will guarantee up to €440 billion of new government bonds issued by any member facing difficulties in the government bond markets. The IMF, in turn, will provide an additional €220 billion of support. In addition, the ECB also changed its stance with respect to buying government bonds and this is meant to ease market stress and rising government bond yields.

The immediate effects were an improvement in risk appetite globally, as equities surged on Monday. However, despite the European Union's strong first step, equity support diminished and euro seemed to remain hesitant on future concerns. Taking parallels with the €700 billion the United States dedicated at the height of the 2007/2008 subprime crisis, which did seem to work - one must note that for the United States this was not just a promise, the money was actually put to work to stabilise the economy.

This is where doubts start to weigh on the single currency; with such amounts coming from individual nations, that are already stretched, it seems that fiscal consolidation is being pushed to a far later stage. Not only that, governments will have to tighten fiscal policy, which might weigh on eurozone growth prospects.

The German opposition is already asking what the maximum costs for Germany could be. It's difficult to quantify this, trying to forecast which countries and how much will be needed is no easy task - and what if a major contributor of the package in turn will need assistance? At some point tax payers might start to refuse waging the bills of other nations.

It is already believed that this has started to show as the recent German election results has been interpreted as being a potential protest from the Germans against having to pay for the others. If such pressure mounts, politicians will start to change their behaviour to safeguard their re-election. This could severely undermine the rescue package. Hence the euro downtrend remains very much in place.

With EUR / USD not managing to maintain a 1.3000 level and actually struggling to keep the 1.27 level up to early this week it is very likely that the pair will keep to the downside. The European Central Bank is introducing non conventional measures at a time when other G10 central banks are starting to normalise policy, hence the US dollar will most likely keep benefiting from being the investor's choice.

Earlier this week the US Federal reserve has reopened currency swap lines with the ECB, BOE and the SNB to help quell an escalating financial crisis in Europe. The Fed also reopened currency swap lines with the Bank of Japan. Currency swaps are meant to help stabilise one's own currency but also to improve liquidity conditions.

Meanwhile, China reports a trade surplus of $1.7 billion for April, amid expectations for a second straight deficit. Policymakers however have little comfort in these figures as exports exceeded imports by a relatively narrow margin. In fact, Chinese leaders are quoted as saying that they would rather wait to be sure that foreign demand has made a sustained recovery before rewinding policies introduced in the midst of the global credit crunch.

China slipped into trade deficit last March and this was mainly attributed to domestic strength rather than external weakness. The Central Bank in its first quarter monetary report signals that the country might be ready to let the yuan move more freely, by adjusting the exchange rate with a reference to a basket of currencies. China has maintained a fixed peg to the US dollar since 2008.

Inflation in China is up to 18-month highs for April, but as a whole it seems China has managed to maintain a healthy economy, keeping the risks of overheating at bay for the time being.

Japanese government officials warned that lessons should be learnt from Greece. Japan is the world's most indebted industrialised nation, with debt forecasts of 200 per cent of GDP for 2011.

The country has so far relied on abundant domestic savings, and domestic investors to cover for all this public debt. Japanese National Policy Minister Yoshito Sengoku warns that Japan needs "to take steps on fiscal discipline".

Upcoming FX Key events

Today: Eurozone ECB Monthly Report.

Tomorrow: US Retail Sales & industrial production.

FX Technical Key points

EUR/USD is bearish, target 1.2450, key reversal point 1.3200.
USD/JPY is bullish, target 98, key reversal point 85.
GBP/USD is bearish, target 1.4300, key reversal point 1.5700.
USD/CHF is bullish, target 1.1000, key reversal point 0.9950.
AUD/USD is bearish, target 0.7800, key reversal point 0.9400.
NZDUSD is bearish, target 0.6200, key reversal point 0.7650.

Mr Bovay is senior trader at RTFX Ltd.

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