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Amid footage of widespread violence and rioting on the streets of Greece in protest to fiscal austerity, parliamentary ministers conducted a vote on the medium-term fiscal consolidation programme put forward by the government under the duress of the EU and IMF. The vote was a precursor to another vote today which will pave the way for the implementation of the proposal into law, setting out the strategy for a €78 billion package of budget cuts and asset sales that is the condition of further bailout funds.

The extent and severity of the protests raise questions about the ability of the Greek government to achieve its growth targets in an economy where GDP is currently shrinking, when the average family will effectively be losing around one month’s salary through the proposed cuts and austerity. The risk of contagion of political discontent within the eurozone is also worthy of consideration.

In the eventuality, the vote was passed by parliament with a very slim majority (155 ‘yes’ and 138 ‘no’ with 5 abstentions), prompting the German economics minister subsequently to say that the Greek vote is “a ray of light”. However, the end of the ‘tunnel’ is still a very long way off. EU members insist that they have set a sustainable course for Greece to return to fiscal rectitude – doubts remain, however, that Greece will, in reality, be able to implement the proposed austerity measures.

In the aftermath of the vote, the brief relief rally in fixed income and credit markets saw 5-year CDS narrow by around 170bps and 2-year yields fall around 200bps, though the market still demands a yield of around 26.5% on its short-term Greek debt holdings. Expectation of an eventual default event out of the eurozone’s weakest member has not been dispelled by the vote, merely prolonged, and now the market’s focus can shift back towards the macroeconomic developments within the eurozone and away from the ‘binary’ outcome of yesterday’s vote.

On the macroeconomic front, the situation is also starting to raise concern. What was originally perceived as a ‘temporary soft spot’ in the road to recovery has developed into a more concerning period of weakness across global economic confidence and demand. As expectations on growth weaken, so do the prospects for the weaker eurozone states to generate the necessary growth rates to fully implement planned austerity, and similarly for the stronger states (Germany, whose retail sales data today was very weak, -2.8% vs. expectations of +0.5%, with weakening price pressures and slowing factory orders) to foster support to the periphery through domestic demand growth.

Attention now may turn to the ECB meeting on 7 July, where Trichet et al have signalled that rates are likely to rise 25bps to 1.50% and whether or not uncertainty surrounding the Greek situation will have diminished enough to warrant the ECB fulfilling their promise on rates. While they are likely to deliver a rate rise, I feel that the downside risks to EUR are growing.

In the UK, a survey of inflation expectations should have provided a cautionary note to the Bank of England as expectations rose sharply in June to 3.9%, from 3.4% in May and just 2.9% in April. I am very much of the view that the spectre of further quantitative easing in the UK was blown out of proportion by the ‘tail risk’ comments of the MPC’s Paul Fisher, and subsequent reflections in the MPC minutes for June. The empirical evidence of a substantial rise in inflation expectations should take such views off the table and cause the MPC further concern about the rising risks of second round price effects. In this regard, I would anticipate the market to begin to bring its expectations of the first UK rate rise back towards Q4 2011 from the current consensus of Q2 2012. This should ultimately prove supportive for GBP.

For the next few sessions, economic data will likely come back to the fore as the key driver of financial markets and from here I believe that economic differentiation will be the main driver in foreign exchange.  Overnight, the relief rally in the EUR and, more broadly, in risk assets has continued but the macro data has been disappointing.  Continued EUR strength from here is certainly not a fait accompli but there are some inconsistencies between usually correlated risk assets that suggest that position adjustment and unwinding is playing a key role in the short term dynamic.

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To paraphrase Winston Churchill, never in the field of (eurozone) political conflict has so much been judged by so many upon so few. Indeed, over the next couple of days, the 300-member Greek parliament will decide the fate of the medium-term austerity plan and its passage into law and, as a direct result, they will shape the future for the 300,000,000 populace of the eurozone.

If you had been listening to some of the triumphant rhetoric from Messrs Sarkozy et al yesterday, you could be forgiven for assuming that they had averted the crisis with the proposal of the ‘voluntary’ rollover of 70% of Greek-held debt. However, in the detail of the proposal, I fail to see how it differentiates itself from the core of almost all proposals so far; that eurozone taxpayers effectively give Greece the money to pay its debts. Ironically, the only vote (at least at the current juncture) is by the Greek parliament as to whether to adopt the austerity deemed required to warrant the release of the next tranche of the EU/IMF bailout fund, and probably further subsequent additional loans and not from the broader eurozone taxpayer.

With growing internal discontent over the prospect of the austerity measures by the indignant citizens of Greece, the ‘Yes’ vote that has been so consistently urged by the entirety of the (non-Greece) eurozone is not necessarily the obvious choice for Greece. There was an interesting discussion this weekend from Wolfgang Munchau in the FT of the argument for a ‘No’ vote in the Greek parliament tomorrow (click here). He argues that the only reason to vote ‘Yes’ would be to delay a default situation until the public sector can achieve primary balance.

Perhaps more pertinently for those eurozone aggressors threatening that Greece will get ‘no more bailout’ if both austerity and privatisation plans are not passed (“there is no Plan B for Greece to avoid default” according to EU Economic and Monetary commissioner Ollie Rehn) is that the additional time is required for the eurozone to unravel the financial implications of an eventual default.

There are another couple of articles worth reading referring to the inevitability of Greece (whose debts are around 160% of GDP) defaulting or restructuring. Both were published in the FT on 23 June (click here) and 21 June (click here) respectively. The longer that restructuring is postponed, the more Greek debt will be owed to official lenders, so the more taxpayers will eventually suffer.

In terms of financial markets, EUR is becoming increasingly vulnerable to the events of the rest of the week. Any delay of the inevitable, in the form of a ‘yes’ vote, may give rise to a relief rally as positioning is unwound but ultimately, EUR is overvalued at current levels.

“You can fool some of the people all of the time and you can fool all of the people some of the time, but you can’t fool all of the people all of the time.”

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This week is likely a defining week for the fortunes and future dynamic of European Economic and Monetary Union.  The binary influence of the next stage of the Greek fiscal crisis will potentially create a great deal of volatility in financial markets and the intense focus of market attention will be centred on the outcome of the two scheduled votes in Greece later this week.

The first session of a three-day debate on the medium term deficit reduction plan is scheduled to begin today, culminating in the parliamentary vote on the 29th June.  This will then be followed by another vote on the implementation of the plan into law from a technical perspective (30th June).  The passing of both votes through parliament are contingent criteria for the release of the fifth tranche of EU / IMF funding by the required date of July 3rd.  A veto on the vote could generate potentially catastrophic consequences, not just for the ability of Greece to remain solvent, but for those countries that are the obvious contagion victims within the eurozone – the rest of the PIIGS.

We have already witnessed Italian yield spreads to German Bunds hitting record wides with Spanish and Irish yields at or near record highs.  Whilst the current market focus is on the very short term, binary, vote outcome, ultimately the issues surrounding the global economy are considerably longer reaching.  US treasury Secretary Geithner suggested over the weekend that the US has “squandered” the last decade’s budget surpluses and it must be the budget objective for the next decade to achieve primary balance.  Moody’s rating agency at the weekend, in highlighting a “dire medium term outlook” in Japan, suggested that a third consecutive ‘lost decade’ is not inconceivable. 

This is where the seriousness of the situation can be highlighted.  The passing of the Greek parliamentary votes this week, whilst not a panacea to the woes of the eurozone are crucial to the formulation and implementation of an EU plan to bailout Greece, and in preventing the contagion effect from making the situation ‘too big to handle’.  Either way, the damage already done to the global economy from the recent Global crises, whatever the specific drivers, mean that the ramifications will be reverberating financial, social and political arenas for a very long time.

Keynes famously once said that “markets can remain irrational for longer than you can remain solvent”.  This is particularly pertinent for the current Greece situation in two respects.  Firstly the situation in Greece, unlike the early effects of the credit crisis, where the issue was one of liquidity, has become a question of solvency.  The implementation of previous austerity measures have failed to address the deterioration of the Greek fiscal deficit and doubts as to the ability of the sovereign to increase revenues and sustain any growth in the medium term with the expenditure cuts required to meet the EU / IMF targets are high.  Secondly, the level of interest rates that the markets required to hold Greek paper at the outset of the crisis were deemed irrational, across the eurozone periphery, what is now becoming clear is that not only were the markets rational, but that the whether or not the Greek parliament pass the votes this week the implications for the Greek fiscal situation, its place in the eurozone and the implications for the eurozone itself are far from resolved – i.e. they can continue to remain ‘irrational’.

In FX the markets are likely to remain very volatile this week, yet the confirmation of the current ‘slowdown’ stage of the economic cycle from the PMI’s will likely see the USD maintain its stronger bias as until we have some clarity on the outcome of the Greek situation.  A weaker global growth profile will continue to discriminate against those countries where the implementation of austerity measures come under pressure (and those heavily reliant on private sector growth) – for now this likely still benefits the USD.

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Following on from Fed Chairman Bernanke’s dismissal of the current threat of deflation and with it the spectre of QE3, USD gained across the board yesterday. In the current environment, where global growth is slowing down, the implications of the slowdown are greater for those countries embarking on fiscal consolidation programmes and this has been clearly highlighted in the UK and, within the eurozone, in Italy and Spain.

The combination of a USD rally and UK growth concerns drove GBPUSD back below 1.6000 for the first time since April Fool’s Day, as the global macroeconomic backdrop showed further signs of a slowdown. The big fear for GBP is that a deterioration of the Greek crisis could spark UK bank risk (a sentiment echoed by Mervyn King this morning), but, with rate hike expectations in the UK now back into Q2 2012, GBP is beginning to look cheap, relative to expectations, and EUR is beginning to look far to expensive relative to the risks.

There are also good reasons to be cheerful in respect of GBP and the UK:

1. Private (non financial) corporations in the UK have exercised prudence through a large part of the downturn and have retained around 30% of profits, or around £70 billion.
2. Investment, despite a very disappointing Q1, continues to outpace that of previous recessions.
3. The private sector has created 520k jobs over the past year, compared to just 143k shed in the public sector.

The big focus of the market, however, continues to be the eurozone. Last night an ebullient statement from the EU that collectively they have “pledged to do what is needed to meet Greece’s July needs” (although the UK has received assurance that it won’t be part of the Greek aid package) sent EUR higher ‘temporarily’ as positions were pared back. But the problems of Greece are a long way from being resolved and EUR will continue to be biased to the downside for the time being.

Yesterday, the Greek Deputy PM suggested that a new Greek aid package will include three elements:

1. A Vienna initiative (for voluntary private sector involvement)
2. State asset sales.
3. An EU / IMF loan (the amount of which would depend on the amount of voluntary take up.

All of this, however, still remains firmly contingent on the medium-term budget cut plan being ratified in the Greek Parliament on Tuesday and the resolve of politicians, particularly on the opposite side of the house, to sway in response to a weekend of planned protests, must be considerable.

The relief rally in EUR overnight in response to the ‘rallying call’ from the EU is likely, therefore, to remain short-lived. It also will have been very disappointing for EUR bulls that it petered out significantly below yesterday’s highs. Markets are unlikely to want to hold risk assets over the weekend and, perhaps less so, EUR assets and, despite the growing consensus that the austerity measures will be ratified in parliament, I for one do not see that as the end of it. The ‘indignance’ of the citizens of Greece is unlikely to calm any time soon and the political, economic and ultimately default risk of Greece remains acute.

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The descriptive narrative surrounding the developments of the Greek sovereign debt crisis has suggested an increasing sense of urgency to the European administration’s need for a resolution. Following on from Eurogroup head Juncker’s comment that the Greek crisis has ‘radically intensified’ and Trichet’s remarks that in his view the ESRB (the European Systemic Risk Board) dashboard is at ‘red’, this morning’s ‘rumour mill’ suggested overnight that the EU/IMF had found a €3.8 billion gap in the Greek medium-term consolidation plan and that the Greek Finance Minister was discussing with the EU/IMF how that might be filled.

While the issues surrounding Greece are intensifying ahead of a weekend of planned austerity protests by the ‘Indignant Citizens’ and the parliamentary vote on the austerity package on Tuesday, broader market and international concern has grown in relation to the possible contagion effects.

This is particularly important when you look at the empirical data. The Bank for International Settlements (BIS) estimated that European lenders held €136.2 billion in loans to Greece at the end of 2010. The bigger issue, however, occurs when you take the ‘G’ out of PIIGS. The exposure to the rest of the embattled periphery is almost €2 trillion. This is why a number of G7 finance ministers have referred to the importance of a ‘firewall’ around Greece and the importance of preventing contagion. EUR remains vulnerable in the near term and sentiment is likely to deteriorate into the weekend along with a broader sell-off in risk assets. In fact, the market fear of contagion is evident in bond markets today as Italy, Ireland, Portugal and Spain are all under pressure (with Italy making new all time ‘wides’ in the spread to German paper).

In the US overnight, the Federal Reserve’s Open Market Committee held rates unchanged at a target between 0% and 0.25%. However, it was the second of the new post-meeting press conferences along with the Fed’s revised forecasts for growth, inflation and unemployment that were the main focus. The data saw growth forecasts revised down slightly for this year and next, along with employment which Bernanke referred to as “weaker than expected”. The slightly disappointing growth view, however, had been expected by the market yet, despite the suggestion that the pace of the recovery was “frustratingly slow” and that “part of the slowdown may be longer lasting”, it was the statement that the “US no longer has deflation risk” which was the most significant market mover.

The removal of the threat of deflation from the Fed’s radar will take the spectre of QE3 (something that had been increasingly discussed of late as the pace of expansion slowed) off the table, for now at least. This has given USD a boost on foreign exchange markets and, while the longer-term issues of the US are still yet to be solved, the more pressing events in Greece are likely to dominate the immediate proceedings and USD should retain ‘safe haven’ status for the time being.

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This morning’s release of the minutes from the 8-9 June Bank of England Monetary Policy Committee meeting was the main focal point now that the first vote (the confidence vote in the government) in Greece passed as expected. The more important vote in Greece, on the ratification of the government’s new austerity measures (a pre-requisite for the passage of the next tranche of bail-out funding) on the 28 June is now key. This vote, after a weekend of planned protests, is likely to be much closer and the next chapter in the Greek debt debacle hangs in the balance, but for now EUR has breathed a short sigh of relief ahead of the more important political wrangling next week.

The BoE minutes surprised markets by bringing the prospect of further quantitative easing back onto the table with the statement “some members thought Asset Purchase Fund [APF] expansion might become warranted”. After the comments earlier in the week from Fisher in relation to the QE debate, it is likely that ‘some members’ refers to Fisher and Posen who continued to vote for a £50 billion increase in the APF at the June meeting. However, the full context of the minutes demonstrate a less clear bias towards easing whilst highlighting the potential risks for a continuation of the current economic ‘slowdown’ in the global economy and in the UK.

The financial markets have now pushed expectations for the first BoE rate rise back beyond May 2012 and that is likely to keep GBP on the back foot in the short term, particularly in conjunction with the increased uncertainty in the eurozone. However, it should also be noted that the BoE Chief Economist, Spencer Dale, continues to vote for a rate hike. If the soft patch ends up being merely a ‘patch’ and the recovery from the impediments to global growth from supply chain disruptions in Japan ease (as recent empirical evidence may suggest), then any resultant pick up in UK growth over the next few months would substantially increase the chances of rate hike in November 2011. GBP remains cheap relative to expectations.

In the US this evening the second scheduled post-meeting press conference from the Federal Reserve is likely to test the resolve of Chairman Bernanke to a greater extent than his inaugural press conference. The weaker data from the US and the rest of the global economy in Q2, which is rapidly coming to an end, combined with the end of QE2 in the US, are likely to bring some challenging interrogation from the Q&A.

It is possible that Bernanke, in a similar fashion to the MPC, reduces the emphasis on the ‘temporary’ nature of the current soft patch in the light of increased global uncertainties. Rising core inflation rates in the US also pose a potential risk to the US, as slowing growth and still uncomfortably high unemployment drive interest rates in the US ever lower. Unlike the situation in the UK, US rates are, in my view, likely to remain on hold for longer than the market has currently priced in and, indeed, once the EUR issues are resolved, whether as a result of a default or a bigger bailout, USD will once again resume its status as the funding currency of choice.

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German ZEW June investor sentiment data this morning was very disappointing, with the index falling to -9.0 from +3.1 in May (the expectation was -3.0). In the commentary, ZEW suggested that “unfavourable US economic data” had burdened expectations and that the US economic data was “relatively cloudy”. Apart from a brief comment summarising eurozone troubles and a statement that the “German ‘economic boom’ may weaken in months to come”, there was no mention of the Greece effect. Therefore I have decided to adopt this approach in today’s comment and choose not to comment on the situation in Greece, suffice to say that the parliamentary vote scheduled for midnight tonight will be a defining event. It is likely to pass and pave the way for a new aid package, but arguably this is now ‘in the price’.

In Australia overnight, the RBA released the minutes from the 7 June Monetary Policy Board meeting, where the RBA saw it “prudent to keep interest rates unchanged”. The RBA also acknowledged the two speed growth in resource (where investment and activity continue to grow) and non-resource (where activity is subdued) sectors of the economy. Indeed, the admittance that further rate rises will be “necessary at some point”, this divergence between the two sub-economies is only likely to widen. The Australian dollar has benefitted significantly over the past couple of years as the Asian growth and commodity booms have benefitted the economy and the interest rate advantage has boosted the carry argument. However, the internal divergence of economic fortunes, potential for a global (albeit temporary) economic slowdown and the growing risk of an external economic shock highlight the overvalued levels of AUD. A sub-parity level for AUDUSD as we move into Q3 would be my central projection.

The UK also came back into focus today with the release of the public sector finance data. The PSNCR (or net cash requirement) was disappointing, rising to £11.1 billion (from £3.5 billion) last month. However, the accruals-based PSNB (net borrowing) showed some improvement and, indeed, after the very disappointing April data, Revenue rose 8.2%, outpacing spending growth of 2.2% on the month to bring the start of the fiscal year back some way towards giving credibility to the £128 billion deficit target for the full fiscal year. This is very important for the UK as political fragilities have started to become more visible and the heavily criticised UK austerity is where Osborne and, by default, the Government have hung their respective hats. Indeed, recent parliamentary rhetoric in the face of calls to water down the austerity was met by the retort “the B in plan B would stand for Bankruptcy”.

The Bank of England’s Fisher has noted that the current inflation surge is temporary and that he has become “more wary about deflation” (although he qualified this by stating that deflation was not the central projection of the BoE). These comments, combined with the implication that further monetary easing in the form of QE is not off the table, have, however, undermined GBP in the near term. For the short term (at least until we get some clarity on the situation in the eurozone periphery), GBP is likely to stay under pressure as European woes, growth fears, political concerns and positioning outweigh longer-term financial advantage and relative value – for now.

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With little on the data calendar today to divert the market’s attention away from the Greek debt situation, speculation, rhetoric and comment are the predominant drivers of sentiment and market prices today.

Over the weekend there was very little evidence of any concrete proposals or plans to deal with the growing uncertainty and nervousness of the situation. What is becoming increasingly clear, however, is the rising pressure on the political structure within Greece. On one side, policymakers are being put under increasing pressure from a populace encamped outside the parliament building, serving as a constant reminder of the discord and angst of sentiment against austerity. On the other side is the increasing pressure from the rest of the world’s policymakers to push through ambitious consolidation programmes and further austerity.

In the political arena, it is apparent that further loan payments are contingent on cross-party backing (or at least a parliamentary majority) for deficit cuts and, perhaps more pressingly, the government passing its confidence vote tomorrow.

A growing number of commentators is suggesting that a Greek default, while likely the worst possible outcome for the rest of the world, may in fact be the best option for Greece. As Argentina proved, taking all the pain in one hit and sharply adjusting the playing field could prove more beneficial than eurozone officials would lead you to believe. The effect of such a measure, however, could prove fatal for the euro and possibly a number of eurozone banks.

However, the eurozone is not the only region with problems and, as I have discussed a number of times on this page, global growth and stability has, of late, been increasingly dependent on the emerging economies while many previously considered ‘major’ economies could be viewed as sub-merging; an issue I referred to on Friday as an ‘Occident waiting to happen’.

The developments of this week will likely shape the sentiment of financial markets for many weeks to come. The EU and euro area Finance Ministers’ meeting today will give us the first clues on progress. Greece’s parliamentary ‘confidence vote’ tomorrow is a necessity for a near-term resolution and, over the next few days, a number of meetings and announcements, comment and rhetoric will doubtless further muddy the waters before a resolution in apparent.

In the US, the FOMC and second press conference from Chairman Bernanke will be very closely watched with particular reference to any growing concern over the current ‘soft patch’. While there is undoubtedly a very high bar for the Fed to consider QE3, US rates continue to slide as the US has considerable problems of its own. Similarly, the growing political disunity in the UK is bringing GBP back under the spotlight and the longer the concerns over the eurozone continue, the more GBP will be punished as the threat to the global banking sector gets priced into the markets.

Divergence of opinion and possible outcomes has increased over the last few days and, in an environment of rising volatility and growing uncertainty (particularly where there is a growing amount of power with indignant citizens and increasing global political pressures), risk management should dominate financial market decisions.

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As we move closer to the all important EU finance meeting in Luxembourg on Monday, the markets are becoming increasingly uncomfortable with the high level of uncertainty.  The growing risk aversion, which has been exacerbated by conflicting rhetoric from within the eurozone, will likely continue to increase as the potential developments over the weekend are extremely diverse.

The newswires are being scrutinised for any further rhetoric about the ‘unknown unknowns’ of Monday’s meeting.  At 12.45am today Merkel and Sarkozy meet in an attempt to bring Germany and France closer together on the issues surrounding Greece – early market talk suggests the meeting will aim to provide a compromise involving private creditors in the funding of the second bailout.  This again highlights how the situation has become as much a political issue as an economic one.  The German population’s discontent about being asked to fund further bailouts is surpassed by the Greek populations angst at the stringent austerity attached to any such bailout. 

There is a growing risk that the political discontent of the two nations at opposite ends of the eurozone growth spectrum, coupled with endless procrastination by eurozone officials (in what admittedly is a very complicated and highly sensitive issue), could foster further dislocation of the eurozone, perhaps even leading to one of them leaving the union.  What is certain however is that if EUR does survive it will surely go on to great things, likely equalling USD for global reserve currency status before long.  Herein lies the markets dilemma dependent on the outcome of the next few days EUR has a very bright, or indeed very dark future.

In some ways that sums up a certain amount of apathy in foreign exchange markets today.  Whilst the stakes are very high for the outcome of Monday’s meeting, it is not clear that we will even get a definitive plan.  We have seen a significant amount of ‘risk positions’ taken off the table this week as concerns over the Greek situation have dominated.  At the moment, however, with little economic data out today and little appetite for new positioning, headlines and short term volatility will dominate.

Commodity currencies will be an important gauge of overall risk sentiment and I would expect the lure of higher yields on position allocation to wane if commodities take another turn lower.  Oil has been quietly declining this week and once we have further information on the eurozone position then I would expect core fundamentals, and perhaps more importantly relative value, to begin to come back to the fore, which may start to weigh on AUD and CAD.

An article in the Chinese business daily overnight suggested that China may issue an important statement on yuan policy on Sunday and with the markets eyes firmly in the Occident, events in the Orient have the potential to catch the market unaware.

Have a great weekend.

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Any discussion of the fiscal, monetary and political position of world’s major economies would perhaps start its construction with a thesaurus reference to the word ‘conflict’ … disagreement, clash, divergence, difference, argument, variance, inconsistency, discord, dispute, tension…

Whether it is in relation to;

the ongoing debate and uncertainty surrounding the ‘solution’ to the Greek fiscal crisis in the eurozone and the implications and connotations for all other member states, governments, central banks and funds, or

the political wrangling in the US over the raising of the debt ceiling and the freeing up of open market funding by the Fed, or

the monetary policy debate in the UK, and the trade-off between domestic demand growth and inflation, or  

the increasing ‘two way’ growth momentum split between the resource states of Western Australia and the more traditional business centres of the East coast, or

how much additional stimulus Japan should provide for an economic recovery that was increasingly fragile before natural disasters struck, or

the impact of the ‘safe haven’ status of the CHF on the interest rate expectations of Switzerland.

While the developed or major economies are busy with their ‘conflicts’ amid pedestrian growth and sub par business and consumer confidence, the emerging or developing world is on a whole different page of the thesaurus.  Former US Treasury secretary Robert Rubin, in highlighting some of the problems that lay ahead for the US economy, suggested last night that “Asia will become the centre of the global economy”.  In terms of growth it already is.

The heightened state of alertness and uncertainty in global economy are causing valuations of currencies to be stretched as ‘safe haven’ currencies like CHF and JPY are being boosted further into overvalued territory.  I have been and remain a USD bear, however in the short term the longer term woes of the US are being equalled for (negative) attention by the growing concern over the Greek debt debacle.  Similarly overvalued commodity currencies such as the AUD and CAD have benefitted from a yield advantage and have also been supported by Asian growth and high commodity prices.  This was highlighted overnight when central bank officials from Canada and Australia both warned of further rate rises – further boosting AUD and CAD.

I have discussed the growing impact of the developed world’s national political debates, on financial markets, fairly regularly over the last couple of weeks and over the next couple of weeks we are likely to reach a crescendo as we witness the end of QE2 in the US, the first scheduled announcement on the Greek fiscal deficit ‘solution’ and possibly an agreement on the lifting of the US debt ceiling

We are now entering what may be the beginning of the end of this period of uncertainty.  This likely means that volatility will pick up further over the coming days and weeks as we get a ‘conflict’ of opinion on the next stage of the recovery.

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The potential ramifications of the ultimate resolution of the Greek debt crisis continue to be the main focus of financial markets, highlighted further by rating agency S&P’s credit rating downgrade of Greece yesterday to CCC from B, maintaining a negative outlook. Greece’s implied market borrowing costs (or bond yields), CDS (or default event protection), as well as the yield spread to benchmark German bonds are all trading at record eurozone highs.

Other peripheral eurozone countries have been intermittently dragged down by the Greek concerns, with the margin requirements for buying Portuguese and Irish debt being raised to 65% and 75% respectively. Spanish bonds remain the key to further deteriorating sentiment for the eurozone as a whole however as yet, despite news that Spanish bank borrowing from the ECB rose to €53 billion in May from €43 billion in April, Spanish yields are remaining relatively well behaved at this point.

EUR has also suffered from comments from the ECB’s Noyer this morning, who brought focus back to the collateral implications for Greek debt if there is a ‘default event’. What constitutes a legal ‘default event’ is also a very complicated area of debate. Noyer stated that, “if we have debt in default, it will be impossible to consider that we have quality debt. Therefore it will become impossible to accept this debt as collateral.” Noyer also warned of a ‘dangerous illusion’ that a debt restructuring or relaxation could allow a relaxation of fiscal plans as “those operations in themselves do not provide any new financing.”

The other core theme of the day so far has been that of global inflation. Overnight, Chinese data showed that prices are still rising at an uncomfortable rate with reasonably firm growth, suggesting that the inflation is at least in part demand-driven. The PBOC continues to reiterate its stance of prudent monetary policy and proactive fiscal policy, highlighted further this morning by a 50bp hike to the bank reserve requirement ratio (RRR). Price pressures in emerging economies were also highlighted by Indian CPI data this morning where the annual rate of consumer price increases rose to 9.06% in May.

Asset bubbles and overheating are becoming real threats for emerging economies and, while in the developed world the threat of overheating is not relevant, bubbles (as I have discussed here before) should be a focus for the Bank of England at least.

In the UK, inflation remains at levels that put the BoE under pressure to justify its credibility and although the core rate of inflation declined in May, the headline rate remained at 4.5%, its highest level since October 2008. MPC member Martin Weale spoke yesterday suggesting that while he can see merit in the argument for unchanged rates at this juncture, “softer data [of late] hasn’t changed his view that rates should rise.” Weale went on to accept that a rate “rise will help the BoE preserve credibility” and that “delaying [an] increase poses significant risks.”

The Bank of Japan (BoJ) raised its economic assessment overnight while keeping rates unchanged. Talk of a further stimulus package also helped to brighten the equity mood in Asia overnight, but the BoJ statement that the European debt situation needs watching is a further sign that the eyes of the world, no matter how serious their own domestic issues, awaits the eurozone response to the debt crisis.

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The last couple of days have provided a couple of perfect examples of how expectations in markets can get ahead of themselves and positioning can drive prices in the opposite direction to the theoretically assumed impact of a given economic event.

This morning’s price action in GBP was very negative as the market was awash with comment and rumour that the Royal Wedding bank holiday in April would have lead to a sharp fall in factory output. In the event the fear of a weak number was realised with a 1.7% fall in industrial production for the month, after the briefest of dips, GBP rose.

The UK’s Statistical Office did, however, qualify the impact of the reduced ‘working’ days in April, suggesting that if you assume production on the bank holiday Friday to have been equivalent to a ‘Sunday’, then impact would have reduced April’s industrial production by 3-3.5% and, while some of the production will have been rescheduled, the event could account for some or all of April’s decline. The fact that the production decline was led by transport, machinery and metals could also be an indication that the supply chain disruptions in Japan had a negative impact.

On the positive side, in the UK there was some evidence that manufacturer’s profit margins were boosted by a fall in input prices on the month and the Bank of England quarterly inflation attitudes survey showed expectations falling for the first time since February 2009. I remain far more bullish for GBP and for the UK than the general market consensus.

Akin to a famous Irish rugby captain’s call to his players to “spread out in a bunch”, ECB President Trichet stated yesterday that he was “absolutely ‘attached’ to the separation principle”. This separation may appear OK in principle, but the reality is beginning to become a different matter. The key driver of the currency and eurozone investor confidence at the moment is the ongoing debate over the periphery and the potential outcome for Greece. What is clear now is that the Eurogroup needs an answer before the market ‘separates’ itself from European assets or, more importantly, the Greeks separate themselves from the euro, and not just in principle.

In essence, EUR bulls got everything they could have wanted from yesterday’s ECB press conference. The much awaited message from Trichet that “strong vigilance is needed on inflation risks”, which remain to the topside, is a clear indication to the market that rates will be raised by 25bps at the July ECB meeting ceteris paribus. His discussions on the growth of the eurozone economy were far more upbeat than the May meeting, where he expressed concerns about the growth outlook (although we think that this was unintentionally over emphasised by Trichet) and his statement that it is “important to look through GDP volatility” suggests that the consensus view of the ECB is that the current ‘soft patch’ is just that.

The price action following the press conference, however, suggested that the market had got ahead of itself and, with the Greek debate still well and truly alive and a July interest rate hike priced in before the meeting, longer-term interest rates began to be reigned back in and EUR was sold off fairly aggressively.

For today, the activity may be a little more contained as the markets digest the opposing potential outcomes for the eurozone. However, next week, as we approach what we are lead to believe is the deadline for a decision on Greece (the Europgroup meeting on 20 June), volatility is likely to pick up once more.

Have a great weekend.

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Overnight the US Federal Reserve’s Beige Book reported a fairly pedestrian outlook on the current state of the US economic recovery, suggesting gradual improvements in labour markets, credit quality and economic activity. This current soft patch in the US (and, indeed, global) recovery has been labelled by many as ‘transitory’ and heavily affected by Japanese supply chain disruptions. Yet the increased uncertainty has left market participants in an elevated state of uncertainty and markets in an elevated state of volatility.

Differing viewpoints and opinions of official rhetoric add to the confusion, and this was again highlighted last night in the US. After the raft of weak data of late and subsequent downward revisions of growth estimates and expectations, Kansas Fed Chairman Thomas Hoenig gave interest rate markets an alternative viewpoint. In his discussions he was forceful in his view that the current zero interest rate policy in the US is “unstable” and “untenable”. He went on to urge a normalisation of rates, suggesting that if it were his choice he would try to get rates to 2%, and that Fed balance sheet assets “can be sold, slowly”.

Hoenig is generally accepted to be at the bullish end of the Fed spectrum (and, as with Andrew Sentance in the UK, some of his views have been taken with a pinch of salt by the markets) but, importantly, as he opined the views that “we have a debt crisis” and that he is “worried about bubbles”, he highlights perfectly the current dilemma of a large proportion of countries – measures to ensure fiscal sustainability in a time of weak or moderate growth with the monetary policy tap full on puts huge pressure on the political leadership. In this regard, the prospects for a large number of countries are firmly reliant on political unity and the ability of politicians to convince the burdened populace. The lack of accord in the US on how to deal with the debt situation and the uphill battle of Greek politicians to convince an ever angrier populace that austerity is the best way forward are two very significant cases in point. Differing views on the potential resolutions of these two factors point to very different outcomes for EURUSD over the remainder of the year.

This afternoon’s ECB press conference will be very keenly watched and, once more, we are on the ‘look out’ for the word ‘very’ in Trichet’s descriptive narrative of his level of vigilance. The inclusion of ‘very’ indicates the likelihood of a rate hike at the July meeting, which is currently the central view of the market. After erring on the side of caution at last month’s press conference, he will be careful not to overcompensate on his view of concern over the current growth trajectory of the eurozone and global economies.

The separation principle is also likely to play a key role in the discussions as weakness in the periphery widens the ‘separation’. Indeed, inflation data from the eurozone in May show that even within the periphery there is a degree of separation with Greek harmonised consumer price inflation at 3.1% year on year and Irish equivalent inflation a mere 1.2% year on year. Clearly, an ‘individual approach’ to the separation principle goes against the objective of monetary union.

Trichet and the eurozone have a long way to go before they can convincingly dispute Alan Greenspan’s accusation of ‘an unworkable scheme’.

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I have discussed recently the growing impetus of national politics on global financial markets and, with ‘independent’ monetary policy across the globe still hugging closely the zero bound for interest rates and with varying degrees of unconventional or quantitative easing already in place, the ‘buck-passing’ to governments and politicians to spur the economic revival will continue to increase.

Last night, Federal Reserve Chairman Ben Bernanke said, “The US economy is recovering from both the worst financial crisis and the most severe housing bust since the Great Depression, and it faces additional headwinds ranging from the effects of the Japanese disaster to global pressures in commodity markets… In this context, monetary policy cannot be a panacea.”

Chairman Bernanke arguably curbed market speculation of QE3 last night and I continue to see this as a last resort for USD. Things may need to get a whole lot worse for the printing presses to be fired up again and, with the threat of deflation not an imminent one and with a declining USD aiding the desire of the Fed to shift the drivers of economic growth further towards investment and exports, monetary policy (panacea or not) looks set to remain unchanged for a long while yet.

While the political debate over the US debt limit continues, and the ‘new’ US debt issuance programme lies in limbo awaiting the outcome, the responsibility for injecting a shot of ‘sustainable growth serum’ into the economy is not the only buck being passed. Another is the currency itself (the buck!), as investors and speculators avert the “excessive holding of USD assets”, and USD declines.

In the UK this morning GBP was hit on the currency markets after a comment from Moody’s rating agency stating that the UK ‘could’ lose its AAA rating on “weak growth, fiscal delays”. While the comments were later clarified as not the central scenario and that the outlook on the UK’s AAA rating remains stable, the comments keep the political determination of austerity measures and their impact on the trajectory of what is already a weak growth profile back into the market’s thoughts.

On the economic data front, further signs of slowing momentum from German industrial production and trade data keep the concern for global export demand and economic growth in the spotlight. It is likely that the recent slowdown is a temporary phenomenon but, in the current environment, investors are more inclined to seek safe havens at any sign of distress.

This ‘risk aversion’ was apparent overnight as USDJPY was driven below 80.00 as a result of safe haven flows amidst Asian equity losses. The IMF stated this morning that “Japan needs to be more ambitious in its medium-term fiscal strategy” and urged further monetary expansion to “ease deflation, boost growth”. Japan highlights the current global dilemma very well, as monetary expansion after monetary expansion continues to push the country’s fiscal position further from equilibrium, and the political leadership merry-go-round prevents a medium-term plan. Ironically, despite the economic, fiscal and political deterioration, the currency remains stubbornly supported. This will not continue but for now, at least in terms of JPY the old adage “any port in a storm” seems apt.

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With little on the data calendar today, the market’s attention has been drawn to the news headlines and, for a distinct change from the theme of late, the headlines have not been about Greece.

The IMF has recently released a report that China will be the world’s largest economy within five years. While this projection may include contentious assumptions of the relative purchasing powers of CNY and USD, the fact remains that, although the political dominance of the US will outlast its economic dominance, China will undoubtedly have a considerably increased presence in the economic, financial and monetary affairs of the global economy in the not too distant future.

Comments on the wires this morning from Chinese officials set the tone for USD weakness in their suggestion that USD will continue to weaken against other major currencies and warned of risks in excessive holdings of USD assets. These comments were later clarified as personal opinion and not the opinions of the Chinese authorities. However, it is a view (at least in the short term) that I agree with.

The economic backdrop has been slightly more positive this morning with above consensus readings for German retail sales and factory orders (closely watched after the recent disappointing trend in global export/domestic demand).

In Australia, the RBA left interest rates unchanged at 4.75% but gave an upbeat assessment of the economic outlook, outlining the improved terms of trade and aggregate demand in an environment where global financial conditions remain accommodative and private investment is picking up. The RBA went on to suggest that “medium-term growth is likely to be at trend or higher.

In conjunction with the more positive macro economic data and projections, the revelation that RBS has been in discussions with the Kuwait Investment Authority has given ‘government owned’ UK banks a boost and has added to the broader equity positivity on the day. Formal and unequivocal IMF backing of the UK’s austerity measures yesterday should also be seen as a longer-term positive. The current market sentiment is very negative towards the UK, with the SONIA interest rate curve now pricing in the first UK rate hike as late as April 2012. In this regard, the market has, in my view, become far too negative.

Sentiment, and the ‘risk profile’ of investor sentiment, remains a dominant factor in financial markets at the moment and I would expect a more positive risk sentiment today to lead to some further declines in USD.

In today’s slightly more positive world, however, there still remains an underlying increased importance of the global political environment after recent elections and internal political battles across the globe. 

In Peru, the left-wing former coup leader Humala’s win has sparked fears of increased taxation on international mining companies. In Portugal, the new PM Coelho has pledged to “go beyond” the EU/IMF bailout package and restore market confidence in the economy. Finally, in Japan S&P were quick to point out their economic concerns and the implicit fact that a “split Diet may impede any new government” however, they also noted that PM Kan’s resignation may be ‘rating positive’ as it may aid the passage of the bond bill.

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Concern over the eurozone periphery – or more notably now ‘the three little PIIGS’ – reached a crescendo during last week, as fears of a Greek default were at their highs (credit markets were pricing in above a 70% chance over a 5-year period). Despite the fact that the announcement from ‘troika’ appeared to contain a lot of positive descriptive narrative but very little information, the market’s fears have been calmed somewhat. Default and restructuring (except in some cases voluntarily) now look less likely and an EU, IMF and possibly even EFSF support package looks more likely, the details of which will likely be agreed over coming days but probably not formally announced to the markets until the Eurogroup meeting on 24th and 25th June. Greek 2-year yields may be closely watched as a barometer for eurozone sentiment.

USD is now vying for the top spot as ‘most worried about’ currency, as the heavy politicking in the US continues to thwart any progress on the debt limit debate. The stronger-than-expected services survey data on Friday gave some respite to fears over the sharp slowdown in the US macroeconomic data of late and gave some credence to the suggestion that the growth slowdown is temporary and significantly impacted by the supply chain disruptions from Japan. Employment in the US, one of the key pillars of the monetary policy mandate, however, remains very weak and the further deterioration of the unemployment rate for May gives further weight to the argument that US interest rates are not likely to rise any time soon.

Ex Federal Reserve Chairman Alan Greenspan said on Friday that the eurozone is “starting to look like an unworkable scheme”. Perhaps people who live in irrationally exuberant glass houses should not be throwing stones at this point!

In the UK the manufacturing data from the engineering employers’ federation (EEF) showed a slight improvement in Q2 as companies benefitted from increasing export orders. The lesser-known Lloyds employment confidence indicator also improved a touch and, with the current level of negativity priced into the economy, the only true negative apparent to me is the ‘double negative’ with which Chancellor Osborne chose to announce that it is “not the case [that] data is showing no growth”.

Indeed, the amount of negativity priced into the UK is highlighted when you look back at the last inflation report which indicated the path for inflation barely coming back to target in the medium term under the (then) market assumption of 50bp of tightening by the end of Q1 2012. Despite inflation running at 4.5%, the market has now barely got 25bps priced in over the same period! With a raft of analysts and forecasters all pushing back their expectations for the start of the normalisation process in the UK to November (from August), I am personally beginning to move the other way and any intimation that the BoE will raise rates earlier than the penultimate month of 2011 will be a significant boost to GBP.

This week the data will be watched very closely. The primary focus is on the ECB meeting on Thursday, where President Trichet is expected to signal a July rate hike. In the UK we also have a policy board meeting. However, the outcome is likely to maintain the status quo. Trade data from the UK and the US will also be closely watched, as will the headlines in what is still a jumpy market. Good luck.

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Politics came back to the fore overnight as the New York based credit rating agency Moody’s suggested that the rating of the US sovereign may be cut if there is no progress on the debt limit.  Moody’s went on to state that “the heightened polarization over the debt limit has increased the odds of a short lived default.”  While I still view the chances of ratings action on the US as unlikely, the suggestion of credit action with the extreme level of debt in the US poses a very significant threat. 

At the current juncture in the global economic recovery, with recent data suggesting a stuttering of growth and a short term (at least) topping out of global domestic and export demand, politics will begin to have greater emphasis and importance to global financial markets.  At this stage of the recovery governments around the world are carrying a heavy debt burden and with a slowdown in economic momentum there is little firepower left to stimulate a tentative consumer, particularly in those countries where austerity measures have been proposed or initiated.  Political risks around the globe are growing.

In the UK the all important service sector PMI was released this morning and despite a drop in the new orders component, that has been a consistent global theme of late, the employment and business expectation components both improved to limit the drop in the headline to 53.8 in May from 54.3 in April.  The index is still clearly in expansionary territory and it is possible that the extra bank holiday for the royal wedding and the timing of Easter could have prevented firms from winning new contracts and hence there is potential for the new business component to bounce back in June.

If we take the weighted average of the three surveys (manufacturing, construction and Services – services being the major component) the result is consistent with quarterly GDP growth of around 0.2%.  This is an improvement from the flat underlying growth over the turn of the year however at this stage of the recovery it is probably not enough to remove the negative sentiment towards the UK and GBP as fears of a consumer slowdown over the summer months ruminate.

The much awaited US employment report this afternoon is the day’s main focus and after the private sector survey disappointed during the week expectations for the release have been revised lower.  The short term risk to the market is therefore likely in a better than the (reduced) expectation, which probably currently stands at around 100k payroll gain on the month of May.  The unemployment rate itself will also be keenly watched after some fairly significant changes to the labour force data over recent months have added volatility.

In what is a very complicated dynamic in global financial markets at the moment, the US payroll data will likely take precedence over the political, fiscal and growth concerns in the short term.  However, markets will have to keep one eye on the newswires as it has been suggested that the troika (EU, IMF and ECB) report on Greece is likely to be released today.

Have a great weekend

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As the European market closed yesterday ahead of the Ascension Day holiday across most of Europe, markets were digesting another slew of weak US data. The manufacturing ISM slid to a reading of 53.5 in May from 60.4 in April, suggesting a more pronounced slowdown in the US manufacturing outlook and, while the sector is still broadly in expansion, the new orders component slid significantly to just above the 50 expansion line at 51.0 from 61.7 in April. This is a component that the market and commentators alike will continue to watch closely in line with increased market concerns about a slowdown in global demand.

Ahead of the all-important US employment report on Friday, yesterday also provided us with the ADP private sector payroll change for May. The expectation was for a continued pace of job creation around the 175k per month rate. However, the disappointing 38k release added to the markets nervousness and led analysts to revise down their expectations for Friday.

The concern over the recent US data, and indeed the broad global slowdown that we are currently witnessing, caused US rates to extend their decline (10-year US yields fell 13bps to 2.94%) and equities to fall by the largest amount since August 2010 as volumes and volatility picked up.

In Europe, sentiment continues to ebb and flow around the Greek situation and, as the release of further parliamentary proposals to repair the fractious sovereign finances of the troubled eurozone state (as well as EU/IMF/ECB announcements on support measures on June 20th) come closer, EUR has found some support. The eurozone has little choice but to throw its support behind Greece, even in the (unlikely) event that the IMF refuses to commit to further funding. Use of the EFSF may reduce the need for national political accord and, while there is likely to be an increased amount of intervention and oversight into Greek finances as well as the ‘voluntary’ agreement of some creditors (arguably mostly Greek Banks) to extend the duration or ease the cost of the loans, the fear of a sovereign default from Greece may now start to diminish.

In Japan, the political situation continues to deteriorate. For me this is a factor that will have an increasing impact on financial markets (particularly FX) over the coming weeks and months. PM Kan survived a vote of no confidence in the lower house of the Diet today by a margin of 293 – 152. However, the acceptance that Kan continues as PM appears to be a reluctant one and perhaps viewed as preferable to the political impasse that a leadership vote could have at such a sensitive economic and political juncture for Japan. In the event, PM Kan had, prior to the vote, pledged to carry on his responsibility until after the post-quake crisis ends, at which point he will pass on the responsibility to the ‘younger generation’.

The current lack of any political unity (made worse by the large number of political parties in Japan) and the severity of the current situation from both its fiscal prudence perspective and the requirement to support confidence and reconstruction in the economy, makes the leadership of the Japanese economy a very difficult job, particularly in the face of such broad divergence of opinion internally. Kan will need to act decisively and with humility, yet it is likely from that JPY will begin to suffer as Kan’s pledge to step down leaves Japan with fragile leadership to add to its fragile economy and fragile fiscal position.

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As we move into the month of June and the first half of 2011 draws to a close, the concerns for the eurozone periphery – predominantly Greek restructuring plans – still dominate the market psyche. There appears to have been some softening of the hard line that Germany has, until recently, taken against any form of restructuring and it now seems likely that some form of ‘soft’ or voluntary restructuring will be proposed before long.

Today has been dominated by manufacturing PMI data from across the globe, which has further highlighted (in most cases) a modest slowdown in the manufacturing growth that has been a strong driving force behind the recovery. The China PMI data is significant in this regard as the official data showed a slowing to 52.0 – a reading still in expansionary territory and slowing from the earlier months of 2011 but stronger than expectations and consistent with a moderation in growth as opposed to the overheating collapse that some have feared.

The UK data was a little more disappointing this morning with manufacturing momentum slowing at a sharper rate than its European peers. There are, however, some important caveats in that the UK seems to have suffered disproportionately from the supply chain disruptions caused by the Japanese natural disasters, and there is also the impact of the Royal wedding, which reduced the number of working days and, potentially, activity. New orders, however, gave cause for concern, falling into contractionary territory, though there were some signs of improvement in both input and output pricing. UK mortgage approvals also slipped to their lowest level since December, perhaps affected by the rise in stamp duty in March, and the extra bank holiday.

That said, we are still very positive on the prospects for GBP, particularly in comparison to market expectations based largely around fears for consumer activity as the austerity measures start to bite. GBP, however, remains considerably undervalued and the relative value boost for GBP remains considerable. Outgoing MPC member Andrew Sentance was on the wires overnight stating his well-versed opinion that the UK needs a “rate rise now to avoid sharper increases” and suggesting that the current level of inflation is “squeezing out some growth in the economy”.

In the US, the slide in interest rates has been a key factor for USD over the past week following a string of weaker-than-expected data. This week is important for USD’s prospects into the halfway mark of 2011, with the employment report on Friday key to expectations. Talk of QE3, which has been largely discounted until recently, has begun to emerge and, while we don’t see this as likely, the fact remains that US rates will continue to stay lower for longer than elsewhere. That is except for Japan, where political concerns are picking up alongside concerns that there is no convincing central plan to boost the economy and, perhaps more importantly, the consumer from the woes of previous months. With significantly negative real interest rates, USD will likely stay on the back foot for some time to come.

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