Expect to see a widening gulf in the Eurozone

STERLING plunged against the euro yesterday as worse-than-expected UK deficit figures exacerbated what was already a strong rally from the single currency. Coupled with solid demand at Spanish, Greek and Irish government bond auctions, this was enough to send sterling-euro down to a three-month low, with the euro also gaining a cent against the dollar.

But do these moves herald the start of a comeback for the troubled euro? Both analysts and traders are divided. Stephen Hughes of forex broker Currencies.co.uk says that yesterday saw as much sterling-euro trading as during the entire previous week, with many piling in to sell euros. But others are taking it as a sign that there will be better euro-selling levels to come: “For those who need to change euros into dollars it’s a good opportunity,” says Hughes. “The question is how long that window is open for given the vast number of different economic releases in the Eurozone.”

With markets so sensitive and quantitative easing (QE) back on the agenda, traders should keep an eye on major data releases – not least the Bank of England’s minutes this morning – to take advantage of movements. Investec’s Lee McDarby says: “This is an opportunity to see what the UK is thinking about QE and that will really throw sterling around a little bit.”

But despite the Eurozone’s seeming resilience, there is still strong scepticism about the health of its periphery: Ireland had to promise an average yield of 4.77 per cent on four-year bonds, sharply up from last month’s average four-year note yield of 3.63 per cent.

Moreover, many suspect the European Central Bank of propping up demand by buying bonds – as it has done in the past (see chart). Lombard Street Research’s Stefano Di Domizio commented: “The auction is nothing to get excited about.”

So in spite of this rally, there are still persistent worries about the future of the single currency. Even if fears over sovereign debt can be allayed smoothly, there is still the potential problem of a widening gap in economic growth between the core and periphery of the Eurozone: while Germany and France recorded second quarter 2010 GDP growth of 2.2 per cent and 0.6 per cent respectively, Spain grew just 0.2 per cent and Greece shrank 1.5 per cent over the same period. Di Domizio says: “Eventually you will have the peripheral countries deflating with high, positive real interest rates, whereas the core countries whose economies are doing relatively better will have negative interest rates – effectively the opposite of what should happen. In a situation like that there is no exogenous adjustment that can repair things.”

It is possible that with more QE in the UK or the US, the euro could continue to be the best of a bad bunch for some time. At some point, however, the Eurozone – and the markets – will have to face its internal contradictions