The debt ceiling deadline for the US looms large in the markets. This caused a sell-off in US equity markets yesterday, which has been followed in the Asian and European sessions today. The Eurostoxx 50 index is down nearly 1% so far, but the real damage is in the Italian market and the AEX Dutch exchange.

European stocks are being dragged lower by the financial sector. The EU debt deal that agreed private sector haircuts on Greek bonds means that some banks may have inadvertently over-stated second quarter earnings as they didn't include the write-down in the value of their Greek debt. This is especially worrisome for French banks, the largest holders of Greek debt, and other European institutions that report Q2 results in the coming days. Total write downs, which will hit both the banking and trading books of European banks, could total $14 billion.

Since earnings are prepared weeks in advance, there may not have been time to include the changes to the value of their Greek debt. This leaves a lot of uncertainty over how the latest Greek bailout will affect the banks' bottom lines, which is weighing on stock prices. Also, if banks have been burnt on low-grade credit they may choose to hold safer or higher graded assets in the future, which could lower their earnings. This is also weighing on stock prices, as investors try to price in the possible effects of both a write down on Greek debt and a structural shift in the behaviour of banks.

The Eurozone debt crisis may also be about to claim another victim. Moody's downgraded Cypriot government bonds and two of the nation's largest banks yesterday. It argued a downgrade was necessary due to Cyprus's large exposure to Greek debt and political turmoil. Cypriot 2-year bond yields are hovering close to 10%, the yield has nearly doubled since mid-April.

Cyprus's finances are fairly stable, its deficit was 5.3% at the end of last year, but the risk is that its banking sector will need to be bailed out due to its exposure to Greek debt. According to reports, nearly 40% of all loans extended by Cyprus's three largest lenders are to customers of Greece. In other words, nearly 20 per cent of Cypriot bank assets are in Greek bonds or loans. This is bad news for a country with GDP of only EUR17bn.

Contagion is well and truly in the air. Italy held a bond auction today, it sold EUR2.7bn of 10-year bonds, below its target of EUR3bn, however yields surged higher. Rome had to pay 5.77% to investors, a huge jump compared with the 4.94% at an auction at the end of June. Both Italian and Spanish bond yields have risen sharply and are close to the highs reached last week, which suggests that on reflection the credit markets are not convinced with the EU's latest deal. This is weighing on the euro, combined with rumours of Berlusconi resigning - swiftly denied.

Debt fears are mounting on both sides of the Atlantic. There is still no breakthrough on the US debt ceiling issue. Although the market seems to be happy that the US won't default August 2nd, they are not willing to buy risky assets in the current environment.

Interestingly, when the debt ceiling was breached in 1995 and 1996, when all non-essential public sector workers were put in furlough and non-essential services were suspended, the dollar actually rose between 1995 and 1997. So the current environment may not be all that dollar negative.

Elsewhere, the Aussie and the Kiwi remain well supported. The RBNZ kept rates on hold last night, and seemed to suggest that rates may have to rise sooner than first thought. The bank cut rates by 50 bp in the aftermath of the Christchurch earthquake, but strong economic growth and rising inflation pressures since then probably means this should be reversed. The bank did add that a strong kiwi may negate the need for more rate hikes, but right now the market has brushed this off.

Economic data is taking a backseat to debt issues on both sides of the Atlantic. German unemployment was stable at 7% this month, however, Eurozone confidence data was broadly lower. In the UK there was more bad economic news. The CBI reported sales survey fell to -5 from -2 in July, suggesting the retail sector is having a gloomy summer.

Data Watch:
United States 13:30BST (0830 ET) Initial Jobless Claims (Jul-23) 415K EXP
United States 15:00BST (1000 ET) Pending Home Sales (Jun) m-o-m -2.0% EXP

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Kathleen Brooks| Research Director UK EMEA | FOREX.com

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