Euro Bounce, Sustainable?

Ideas that at its meeting tomorrow the ECB may take additional measures to stem the financial crisis that has threatened this week to spread outside the periphery and toward countries like Belgium, are prompting some position adjustment in both the foreign exchange and fixed income markets. While observers are not at a loss at making recommendations to policy makers, the immediate challenge, however, as ECB President Trichet point out yesterday, many of the recommendations, like a European bond, is for the governments to decide not the central bank.

However, one possible course that Trichet specifically did not rule out was that the ECB could step up its purchases of sovereign bonds. Recall that thus far the ECB has purchased about 67 bln euros of sovereign bonds through last week and attempts to sterilize the impact on money supply. The initial decision to buy sovereign bonds in the first place was controversial and opposed by Germany's Weber and Stark. However, as Trichet noted yesterday, the decision is made by the 22-strong governing council.

I have argued before that the critical difference between the ECB and the Fed may not lie with a formal inflation target or a dual mandate, as both get blurred in practice. Rather the more significant difference is that at the Fed the Board of Governors is a strong core, with a few exceptions outnumbering the regional presidents. The ECB is the opposite, smaller core and larger representation by the regional (national central banks).

If the ECB does extend its bond purchase program and especially if it ceases its sterilization operation, some will sell the euro on quantitative easing, but as we have seen in the dollar's case it is not always that simple. On the contrary, a large scale bond purchase program would likely help stabilize the debt crisis through that channel fuel a stronger recovery in the euro.

Strong Chinese PMI, 4-month high in the euro zone PMI, German Oct retail sales twice as strong as expected, the highest UK PMI since 1994 is also spurring some position adjusting in the direction of taking more risk today. Emerging market equities are posting their biggest rally in two weeks and European stocks are recovering from 8-week lows recorded yesterday. Peripheral European bonds have rallied, pushing down yields 8-15 bp, though Belgium bonds are flat, showing no recovery.

Despite the euro's boucne it remains wihtin yesterday's trading range. A move above $1.3150 is needed to solidify the tone. I am not convinced this will happen. The hourly momentum indicators I look at are stretched with the 1% rally off the lows and showing some divergence. Many market participants were looking for a bounce to sell into.