Recent: The measures taken at EU summit of 8-9 Dec'11 failed to convince markets that progress was being made to solving the debt crisis. Safe haven bonds soared.

In the course of Jan'12 the sovereign debt crisis eased while global growth indicators turned up, for a while reducing the demand for safe haven Bunds.

Towards end-Jan'12 the bond market improved again as America's Federal Reserve undertook to prolong its expansionary monetary policy stance further into the future.

But optimistic global growth indicators in week 5 boosted stock markets and weakened Bunds.

For longer term trends in the government long bond market and some background see below.

Earlier: Bund yields plunged in Q2'11 and Q3'11 as the euro zone's sovereign debt crisis deepened. The bond yields of the most indebted countries soared. Italy's and Belgium's credit rating outlooks were reduced and the debt of Greece, Portugal and Ireland became junk.

The business surveys, moreover, indicated a steep slowdown in growth and an easing of inflationary pressures. Stock markets plunged. All this brought Bund yields well below the lows recorded in 2010. At the same time the yields of the bonds of the most indebted euro zone countries reached crisis levels. Bunds were the ultimate safe haven, yielding less than comparable Treasuries.

 In the final months of the year Bund yields fluctuating widely around exceptionally low levels as fears about the debt crisis and a possible global recession waxed and waned. But a failed German bond auction in Nov'11 undermined Bund's safe haven status and Bund yields rose above Treasuries, a reflection of how severe the debt crisis had become.

Germany too was being dragged into the sovereign debt crisis. For some this signalled the coming end of the EUR. For others it signalled that the burden of assisting the most indented euro zone countries would increasingly be born by Germany, undermining its credit worthiness.

The panic following Nov'11's failed German bond auction faded towards the end of Nov'11 and the yield spread with Treasuries shrunk. Bunds resumed their safe haven function.

For longer term stock market chart see below.

Recent:  Hopes that the authorities may at last be getting a grip on the euro zone's sovereign debt crisis were dashed when the 8-9 Dec'11 EU summit failed to come up with convincing measures. The EUR plunged.

With growth prospects clearly improving in the US, but not in the euro zone, the EUR has come under renewed downward pressure early in the new year. Moreover euro zone money market rates are in decline after the ECB's latest injection of liquidity while the debt crisis drags on.

By mid-Jan'12 the debt crisis eased as Italy, France and Spain all sold bonds at lower yields. The EUR recovered some lost ground. The EUR was further boosted in week 4 as Federal Reserve eased its monetary policy further.

For the long term trend in the EUR/USD exchange rate and some background on the ECB's exchange rate policy see below.

Earlier:  The EUR was supported in H1'11 by the wide yield gap between US and euro zone money market rates. The ECB raised rates while the Federal Reserve maintained its exceptionally accommodating monetary stance. The 3-mnth EURIBOR yield rose to 1.6%  in Jul'11 while the US 3-mnth LIBOR remained at 0.25%.

The EUR was at the same time undermined by the euro zone's sovereign debt crisis. The balance of positive and negative factors brought a basically sideways movement with, however, considerable week-to-week volatility.

This prolonged sideways movement was broken after the ECB adopted a dovish tone at its Governing Council meeting of 8 Sep'11. This encouraged the view that the ECB may cut its interest rates later in the year, reducing the gap between euro zone and US money market rates. The EUR plunged.

The renewed intensification of the debt crisis in the weeks that followed added downward momentum. But in Oct'11 the EUR recovered on hopes that the authorities may at last be getting a grip on the crisis.

These hopes were dashed in Nov'11 after the bonds of Italy and Spain came under attack and fears intensified that the required corrective measures would be difficult to implement.

Real effective exchange rate: EUR gains competitiveness as sovereign debt crisis intensifies again

Since 2002 the EUR not only appreciated strongly against the USD, but also on a trade weighted basis, raising concerns about the competitiveness of euro zone production, though there is little evidence that it had been a major factor.

The rule of thumb is that a 5% appreciation of the real effective exchange rate of the euro has about the same depressing impact on activity as a one percentage point rise in interest rates (other things being equal).

In H2'08 the EUR recouped competitiveness for which its exporters were undoubtedly grateful. In 2009, however, the EUR again appreciated, mainly because of the collapse of sterling (the UK is the euro zone's main trading partner). During 2009 the trend was again one of trade weighted appreciation.

In H1'10 the EUR weakened dramatically under pressure from the worsening sovereign debt crisis, improving its competitiveness substantially. The strengthening of the EUR which followed in Q1'11 was not sustained as the sovereign debt crisis steadily worsened.