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The euro rose to a new seven week high against the US dollar and also made progress against the pound

The euro rose to a new seven week high against the US dollar and also made progress against the pound as the markets gain in confidence that a long awaited solution to the euro zone sovereign debt crisis may be within touching distance.

The euro was boosted by hopes of bond buying by the European Central Bank (ECB) as the results of the latest bond auctions in both Spain and Italy came in better than expected.

Meanwhile the dollar remains on the slide, trading yesterday at a three month low against the pound as the markets await Federal Reserve Chairman’s Ben Bernanke’s words at the Jackson Hole symposium at the end of the week. The markets will be on the lookout for any hint that the Fed will embark on a third round of Quantitative Easing (QE) to boost the flagging growth rate of the US economy.

September promises to be a pivotal month for the euro. Next week the ECB hold their monthly policy meeting, the week after the German Constitutional Court is expected to rule on the German contribution to the euro zone’s permanent bailout fund, the European Stability Mechanism (ESM). The week after that, Greece is due to repay a multi-billion euro bond and requires the troika (ECB, EU and IMF) to release the latest tranche of funds from its latest bail-out.

In Germany, its main opposition party the SPD is calling on party leader and the nation’s Chancellor Angela Merkel to clarify her position on the issue of the ECB purchasing sovereign debt while Free Democratic Party parliament member Frank Schaeffler is accusing the ECB of “unlawfully changing the fundamentals of the euro, (thus) becoming the real systemic risk.” Schaeffler compares this control of credit spreads to price controls on milk in the 1970s and warns that it would only cause a “new wave of debt and destruction of wealth”.

Germany has been the most open and vociferous opponent of the concept of the ECB purchasing government bonds in order to help peripheral countries such as Spain and Italy lower their borrowing costs. While ECB president Mario Draghi has promised to do whatever it takes to preserve the euro, he has to walk a fine line in backing up his fine words with action whilst keeping policy within set guidelines.
Despite the better than expected bond auction results yesterday, problems persist as can be evidenced by data showing that Spain suffered the worst run on his banks’ deposits since the launch of the euro, losing funds equal to 7% of GDP in July as data from the ECB shows the outflows from Spanish commercial banks reached €74 billion in July, twice the previous monthly record. This brings the total deposit loss over the past year to 10.9%, replicating the pattern seen in Greece as the crisis spread.
Better news out of neighbouring Portugal with the troika inspectors praising the country’s progress on fiscal retrenchment. “We don’t believe the government can do more,” Peter Weiss, a European Commission economist, said after the third assessment. Markets also indicate some tentative improvement. Lisbon’s two-year bond yields have recently dipped below 5%, the lowest level in more than a year and the benchmark 10-year bond yield briefly fell below 9% earlier this month and is one of the best performers in Europe this year.
Even domestic household confidence is showing signs of recovering this year, despite the dismal state of the domestic economy and rising unemployment according to a Deutsche Bank report.
Nonetheless, investors and economists warn that Portugal still faces daunting challenges. The economy is forecast to contract by at least 3% this year while unemployment has risen above a record 15%.