In the eye of the storm

The rout in global markets continues as the bad news mounts up. Failure to achieve concrete results from the meeting of eurozone finance ministers yesterday together with intensifying banking sector concerns and weaker global manufacturing surveys left a sour taste for investors. Aside from the selloff in global stocks the EUR fell to an eight month low and looks on track to test psychological support around 1.30 versus USD.

Attention continues to be focussed on the Greece. Greece’s failure to meet its deficit targets did not appear to derail the prospects of the country receiving it’s next loan tranche but discussions between the Troika and Greek officials are ongoing and payment to Greece may not now be made until November. European officials have indicated that they will reassess Greece’s deficit targets combining 2011 and 2012 targets, suggesting some leeway for Greece to be able to qualify for the next loan tranche.

One reason that markets are reacting negatively is the hints from Eurozone officials that the agreement reached in July on a second bailout for Greece may need “technical” revisions which has been perceived to imply bigger write downs for Greek bond holders compared to the haircuts of 21 percent agreed back in July.

There seems to be no end to the problems for the EUR and markets are clearly running out of patience. Over the near tem there appears to be little to prevent sentiment from deteriorating further. What is needed is a clear plan and this is clearly not forthcoming. Greece remains in the eye of the storm but as yet there is no plan to ring fence the country and avoid a deeper fallout globally.

Elsewhere risk currencies in general continue to be hit, with the AUD in particular facing pressure as the RBA hinted at prospects of interest rate cuts in the weeks ahead. The outright winner is the USD and further gains are likely as risk aversion continues to intensify despite the fact that the US has it’s own problems to deal with. As we move further into October the potential for more volatility remains high.

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Greek Confusion, India Tightening

It is highly interesting that markets could take fright from a rate hike in India but this appears to be what has happened. India’s surprise 25bps rate hike has provoked another bout of risk aversion whilst the lack of any concrete agreement on a framework for a Greek bail out dealt a further blow to confidence. FX tensions between the US and China have not helped, with China threatening retaliation to any US move to name the country as a currency manipulator in the mid April US Treasury report.

Should we really be worried by a rate hike in India or China? Whilst the India rate move reflects the fact that emerging market central banks are moving far more aggressively to raise rates than their G7 counterparts, global fears that India’s move will dampen recovery prospects are unfounded. Monetary tightening in India and China and other economies is taking place against the backdrop of economic strength not weakness.

As such the global impact on growth should be limited. Rising inflation pressure in Asia is reflection of the much quicker economic recovery, relatively low rates and undervalued currencies in the region. Not only will central banks in Asia have to raise interest rates but will also have to allow further currency appreciation.

There is still plenty of confusion about a bail out for Greece ahead of the 25-26th March EU summit. German Chancellor Merkel dampened expectations of a bailout by stating that it was not even on the agenda for the summit. In contrast, EU President Barroso has pushed EU members to agree on an explicit stand-by aid agreement for Greece as soon as possible.

There is also disagreement about whether there should be any IMF involvement, with Germany favouring some help from the Fund whilst France opposes it. Meanwhile, the Greek Prime Minister has reportedly given an ultimatum that should no aid plan be forthcoming at the EU summit, Greece will turn to the IMF for assistance.

All of this suggests more downside for EUR/USD, with a test of support around 1.3422 looming. In the event that the EU summit offers good news for Greece, EUR/USD sentiment could turn quickly so a degree of caution is warranted. Speculative sentiment for the EUR has improved according to the latest CFTC Commitment of Traders (IMM) data for the week to 16th March, with net short EUR positions at their lowest since the beginning of February. Nonetheless, the short covering seen over the past week could come to an abrupt end should there be no aid package for Greece.

The most volatile currency over the past week was GBP/USD and after hitting a high of around 1.5382 it has slid all the way back to around the 1.5000 level. Much of this was related to the gyrations in EUR/USD but GBP took on a life of its own towards the end of the week and has not been helped by comments by BoE MPC member Sentence who highlighted the risk of a “double-dip” recession in the UK.

GBP is highly undervalued and market positioning is close to a record low but a sustainable recovery looks unachievable at present. Attention this week will centre on the 2010 UK Budget announcement and markets will scrutinise the details of how the government plans to cut the burgeoning budget deficit. Failure to restore some credibility to the government’s plans will dent GBP sentiment further and lead to a sharper decline against both the EUR and USD.

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