Markets remain wary of Mario Draghi’s pledge to save the euro

Markets remain wary of Mario Draghi’s pledge to save the euro

Good morning and welcome to today’s foreign exchange market commentary on Tuesday, the 31st of July.

As the world waits for the European Central Bank to deliver on its promise to stabilise interest rates in the region through bond purchase programs, the upside is obvious. Lower interest rates will free up funds that will help countries with tighter budgets to spend more on growth-centric programs.

The banking sector however, is in a worse shape. Each country’s banks enjoy an implicit government support. Trust in banks erodes as the government’s ability to support banks dwindles. Even well managed banks in relatively stronger economies would face problems while Spanish banks are in real danger following the real-estate bubble burst.

European leaders failed to recognise that countries offer an implied subsidy to the banking system in the form of confidence. The confidence that governments will support banks in case trouble arises is the implied subsidy, and stronger the government, larger is the subsidy.

It’s remarkable that the flight of capital has been limited in the absence of a level playing field. A common guarantee can avert market distortions and the differential implicit subsidy that European leaders clearly failed to see in the first place.

The single market principle behind the creation of euro was supposed to allocate labour and capital efficiently. Though the intention was noble, tax differentials ensured capital didn’t flow where social returns were highest. The German banks enjoy an advantage over other countries due to the implicit subsidy. The ECB’s mandate is price stabilisation. But inflation is hardly the biggest macroeconomic challenge being faced by Europe.

CURRENCY RATES OVERVIEW

GBP/EURO – 1.2801
GBP/US$ – 1.5708
GBP/CHF – 1.5382
GBP/CAN$ – 1.5720
GBP/AUS$ – 1.4942
GBP/ZAR – 12.8352
GBP/JPY – 122.90
GBP/HKD – 12.1815
GBP/NZD – 1.9390
GBP/SEK – 10.6974

EUR: The single currency retreated yesterday against the GBP and the USD ahead of the ECB’s policy decision meet on Aug 2 over speculations that the central bank may reintroduce its Securities Market Program under which it bought bonds of peripheral countries to bring down high borrowing costs. Markets remained wary of Mario Draghi’s pledge to save the euro as German opposition came out in the open again as a government spokesperson reiterated Berlin’s position on any further debt mutualisation moves. At current level, the market seems to have discounted last week’s Draghi-inspired rally and don’t be surprised if the euro witnesses steep decline on Thursday if the ECB fails to deliver on its promise. The tier-1 economic data calendar is light on the ground today and the common-currency is expected to remain range-bound. The GBP/EUR opens at 1.2792 this morning.

USD: The ongoing weakness of the EUR/USD pair coupled with poor UK economic data dragged the GBP/USD pair from its five-week highs yesterday as the cable traded at 1.5673 against the greenback. A report from the Confederation of British Industries showed retail sales growth slowed in July while Bank of England data showed UK mortgage approvals eased in June, confirming the general softness of the UK economy that helped little to shore up investor confidence in the Pound. The USD index – a barometer of the dollar’s strength against six leading currencies, inched up as the greenback gained ground against the UER and the GBP. Markets are expected to remain caution ahead of the FED’s FOMC meeting starting today while the ECB’s monetary policy meeting begins on Thursday. No tier-1 Economic data is due from the UK while we have a raft of month-end releases from the other side of the pond. The GBP/USD opens at 1.5697 this morning.

Have a great day!

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