Wednesday, 26 June 2013

Where Does Chancellor Merkel Really Stand?

Ralph Shell, Excel Analyst

Where Does Chancellor Merkel Really Stand? For the past 14 years Angela Merkel has been the leader of her party, the Christian Democratic Union, and since 2005 she has been Germany's leader.  A criticism of Merkel is that she is too cautious, often watching the direction of the political weather vanes before committing.  For many surviving politicians this is not an uncommon trait.

According to the current issue of Der Spiegel, Merkel appears to be making another change.  They report:

"German conservatives have long been passionate supporters of increased European integration. But lately, Chancellor Angela Merkel has applied the brakes to the process. Brussels, she believes, has become part of the problem.

Just one year ago, the German chancellor was calling for "more Europe, not less." But now she has completed a radical about-face. At the EPP summit in the Vienna Kursalon concert hall last Thursday, Merkel showed that she had transformed herself into an EU-skeptic ... She is increasingly distancing herself from the foreign policy tradition that the CDU, more than any other party, has maintained and upheld since the postwar period."

This is the campaign season when politicians say what they think the voters want to hear, before they get into office and then do what they want.  But have the German voters really become eurosceptics, possibly reacting to Brussels over-reach?  Or, are they frightened about the German costs of future bailouts?

There is good reason for concern.  In the Telegraph (Sunday, 23rd June 2013), Evans-Pritchard warned about the possibility of an Italian default within six months.  The story was written by an author consistently skeptical of the euro project, but the source was the second largest bank in Italy.  It noted that:

"The report warned that Italy will "inevitably end up in an EU bail-out request" over the next six months, unless it can count on low borrowing costs and a broader recovery."

The Italians do have a serious problem.  The Bernanke "taper talk" has sent shock waves through the bond markets.  Italy has €2.1T in sovereign debt, so higher rates hurt a lot.  The 10-year bond traded at 4.85% Monday 24th June, much higher than 4.05% on the 15th of May, but the short end of the yield curve is also appreciating.

Recently, the Italians had been borrowing short-term to finance their long-term debt obligation which is always risky business.  Should the taper talk continue to spook the bond market, the Italian government refinancing is indeed vulnerable.

The entire end of the yield curve will be affected,  It will be quite important to watch the bond rates as well as the results of future auctions. Serious strength in the Italian debt market will be a cause for concern in the euro (FXE, UUP UDN).

Since the May 28 COT Report there has been a massive shift in spec positions in the euro,  Then the specs were short 109.2K in the CME futures markets.  The most recent report showed the specs are now long 10.5K contracts.  This would suggest that the recent run up to the 1.34 was short covering, plus some traders that bought because of the market action.

Market action the past week probably flushed out some of the new longs, but as we approach the 1.30 handle, support appears. The list of potential euro negatives is long.  It is our preference to be short but feel it is best to wait for a modest rally.
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