BZ:Euro Edges Lower ahead of ECB's Interest Rates Decision
The euro edged a bit lower against the U.S. dollar on Thursday, ahead of the ECB's monthly interest rate meeting. Presently, the euro retreated 0.26% against the greenback to trade around $1.4287. However, the euro is making massive gains against the Japanese yen, after the Japanese currency tumbled following an intervention by the Bank of Japan. At the moment, the euro trades around ¥113.79, or 3.2% above its previous close.
The European Central Bank is widely expected to leave its interest rates on hold. At the moment, the Eurozone's interest rates are set at 1.5%, above 0.5% in the UK and near zero levels in the United States, Switzerland and Japan. The ECB raised its interest rates by a quarter of a point in its July meeting, following concerns that Germany and a handful of other economies in the Eurozone center are overheating. However, the ECB's decision made life a little bit more difficult for the debt-ridden Eurozone periphery as their borrowing costs increased. Since the last ECB meeting, data generally pointed out to a slowdown in inflation, so there is little need for the ECB to raise interest rates once again.
On Wednesday, the Italian authorities held an emergency meeting with the EU officials regarding Italy's debt problems. In addition, Italy's Prime Minister Berlusconi spoke in the parliament in order to reassure investors that Italy's financial position is stable. In today's trading, markets seemed to calm down as yield on the Italian 10-year bonds is back below 6%. At the same time, the Italian/German bond spread has fallen 16 base points to 353. Good news is also coming from Spain as the Spanish/German bond spread down 16 base points to 370.
Not everyone is convinced that Italy and Spain have turned the corner. According to the Centre for Economics and Business Research, a UK think-tank, Italy is likely to default, while Spain should be able to avoid the same faith. Both countries are suffering from a weak economy and high debt. However, while Spain should have bigger issues in eliminating its budget deficit, Spain's overall debt level is far smaller than Italy's. In fact, Italy has the second highest debt-to-GDP ratio in the Eurozone, right after Greece. If the Italian economy does not pick up very soon, the Europe's fourth largest economy might end up like Greece, Ireland and Portugal.
So far, the Europeans were mainly concerned with preventing the debt crisis in Greece from spreading into Spain and Italy. However, there is a possibility that the contagion might come from across the Atlantic. Spanish and Italian authorities will be watching closely for the S&P's reaction to the new U.S. debt deal. S&P has been the most vocal critic of the three rating agencies of the long-term sustainability of the U.S. public finances. In fact, the rating agency has threatened to cut its triple-A rating on the U.S. debt unless drastic reforms are implemented. Now, it faces a challenge some analysts have described as a lose-lose situation. On the one hand, S&P can follow up on its promise and slash the U.S. credit rating since the two parties did not agree on a large debt reduction plan, and the plan should be implemented only after the next year's election, which casts some doubts if these measures are ever going to be implemented. However, if S&P decides to punish the United States, it might come under enormous political pressure. On the other hand, if the rating agency lets this one slide, it might lose its credibility. The rating agencies have been heavily criticized for not predicting the financial meltdown in recent years. As a result, they cannot afford to lose more of their credibility.
If S&P decides to downgrade the U.S. credit rating, the consequences might be severe for Italy, Spain, and the whole of Eurozone. The U.S. government bonds are the backbone of the global financial system, since they are considered to be the safest investment. Therefore, any credit rating downgrade on the U.S. debt may start a panic, which could push investors out of riskier investments, including the Eurozone periphery bonds, and into safe-havens like the Swiss franc and gold. On Wednesday, the Swiss National Bank has intervened in order to stop the franc from rising even higher, but gold looks set to break the $1,700 mark very soon.
