November 13th 2011: Weekly preview - Storm centre moves to France
Euro-zone leaders have got what they needed in Italy and Greece with the appointment of two technocratic governments and the resignation of Prime Minister Berlusconi. For now, the risk of civil dissent has eased, but there will be little time to celebrate as the fundamental vulnerabilities and contradictions will continue and pressures are likely to build again very quickly. Some time has been bought, but the underlying cost has again been severe. The relentless shift of capital out of the more vulnerable economies and banks will continue to expose the region to fresh turmoil as the flood water finds fresh cracks to exploit. The wider global impact is also likely to be increasingly damaging as lending is restricted.
The immediate focus will be on whether the contagion threat has been lifted. Alongside the panic surrounding Italy last week, there was a notable increase in strains elsewhere. Spanish yields continued to rise and there was also a further widening in yield spreads between German and French bonds to record levels. There were also further tensions in Belgium and Austria as financing conditions continued to tighten with fresh concerns that Austria was set to lose its AAA rating.
The trend in yield spreads over the next 48 hours will be extremely important for market sentiment. If French yield spreads fail to narrow or indeed widen further, then this will be a clear vote of no confidence in the Euro-zone structure as a whole. This would immediately put the focus back on the ECB and Germany as demands for the ECB to increase bond purchases through quantitative easing would reach an even higher crescendo. Dollar Libor rates will also need to be watched very closely. There was a further widening last week and the underlying pace of increase accelerated as 3-month US rates approached the 0.50% level.
If French yield spreads widen further and dollar Libor rates continue to increase, there is no prospect of a sustained improvement in global risk appetite and commodity currencies will face renewed selling pressure during the week. Trading the Euro through the fog and internal contradictions remains challenging, but selling EUR/USD on any move towards 1.40 must remain the best approach.
The financial sector will continue to be extremely important given the threat of a banking crisis and credit crunch. There is an important risk that emerging-market confidence will deteriorate as international banks pull funds back to their core. The principal effect of this will be to undermine risk appetite and put renewed selling pressure on commodity currencies. Euro trading will remain as
The US data will be important, primarily in seeing whether the US can maintain the slightly more confident tone seen over the past week. Another solid reading for retail sales on Tuesday would help underpin confidence. The New York Empire survey on the same day and the Philadelphia Fed index on Thursday will also be important indicators of the US pulse. The data will inevitably be a double-edged sword for the dollar as solid data would also lessen the threat of a steep global downturn.
There are important UK economic events, although the underlying impact may be limited given that international trends will tend to dominate in the short term. The latest inflation data and unemployment figures on Tuesday and Wednesday respectively will given important insight into underlying conditions. The Bank of England inflation report will also be watched very closely on Wednesday. As far as inflation is concerned, the bank will again predict a sharp fall, in inflation during 2012. To some extent they will inevitably be correct as the 2011 tax increases will come out of the calculation, but the markets realise that the inflation target is dead and buried for the time being at least.
Of greater interest will be what the bank says about the banking sector. The massive UK debt level has increased underlying vulnerability and leaves the UK at the mercy of global capital flows. So far, the UK position outside the Euro area has been a huge benefit as it has become a haven for capital inflows. Any renewed international retreat from the UK banking sector would trigger a sharp reversal in UK fortunes and these will be very nervous days at the UK Treasury.
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