Eurozone crisis: strong rally falters as euro loses ground

European Central Bank's pledge to save euro hampered by investor doubts as currency slips on foreign exchanges

The strong rally in Europe's financial markets in the wake of the European Central Bank's pledge to save the euro showed signs of running out of steam on Monday as investors raised doubts about the ability of the Frankfurt-based organisation to deliver on its promises this week.

With markets anxiously awaiting the outcome of the ECB's policy-making meeting on Thursday, stock markets in Madrid and Milan continued their rallies but the euro lost ground on the foreign exchanges and interest rates on Italian bonds rose marginally.

But fears were raised about the possibility that strong German opposition to the radical steps being floated to end Europe's two-and-a-half-year-long sovereign debt crisis would lead to a disappointing outcome after the tough talking by the ECB's president Mario Draghi last week.

Tim Geithner, the US Treasury secretary, expressed America's concern about the state of the European economy in informal talks with Germany's finance minister, Wolfgang Schäuble. But a statement issued after the meeting contained no specific measures for easing the pressure on the eurozone's weaker economies.

Signs that problems on the periphery of monetary union have started to affect confidence across the whole of the 17-nation single currency zone were evident when Spain announced that its economy had contracted by 0.4% in the three months to June, following a 0.3% decline in the first three months.

Meanwhile, business sentiment and consumer confidence in the eurozone fell to their lowest levels in almost three years.

"Most countries saw very weak or declining sentiment in July – not just the struggling southern periphery countries but also the core northern eurozone countries," said Howard Archer of IHS Global Insight. "Indeed, there was a marked drop in sentiment in Germany, indicating that it is increasingly being affected by the problems elsewhere in the eurozone."

Standard & Poor's, the rating agency, cut its growth forecasts for the eurozone and said there was now a 40% risk of a double-dip recession.

Draghi's comments at an investment conference in London last week prompted speculation that the ECB might plunge back into the financial markets and resume buying the bonds of countries facing high borrowing costs on their debt. Some analysts believe that Draghi might be prepared to face down the German government and start buying bonds directly from eurozone governments. A cut in the ECB's key interest rate will also be discussed at Thursday's meeting.

"[Draghi] has upped the stakes massively," said Peter Allwright, head of absolute return on rates and currency at RWC Partners. "He has gone all in, but the market will be calling his bluff."

The nature and timing of any action is unclear and eurozone officials have said September is shaping up to be a "make-or-break" month in the search for a resolution to the three-year-old debt crisis

Spanish 10-year yields dropped 13 basis points to 6.64%, having fallen from levels around 7.5% seen before Draghi's comments. Italian 10-year yields were seven basis points higher at 5.88%.

"What the ECB is trying to do is to stabilise the market to drive yields down," said David Keeble, global head of rates strategy at Credit Agricole.

"They are likely to come out and say that they are doing SMP (bond purchases) not instantly but that they're more inclined to do it if the market remains volatile. If we can get the stability back then we'll start to grind lower in yields."

On the currency markets, the euro lost ground against the US dollar following its recent sharp gains and closed at $1.2244 in Europe. The FTSE 100 closed up 66 points at 5934.


Larry Elliott, economics editor

The GuardianTramp

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