Core European stocks indices have pushes off their lows this morning but market sentiment remains very vulnerable.  There is now a lot more at stake than whether or not Greece can initiate budget reform.  If confidence and risk appetite continues to be quelled across markets, the global economic recovery could falter.  

In the wake of the ballooning of budget deficits that followed the global economic crisis, investors are examining each country's risk of sovereign default very carefully.  Yields on Greek, Portuguese and Spanish 10 yr bonds have all pushed higher over the past 24 hrs as funds flow to perceived safe havens.  US treasuries have been the natural beneficiaries of these flows.  Interestingly yields on UK gilts are lower relative to the tail  end of last week, with this market not been singled out as holding significant default risk despite the GBP 163 bln UK budget deficit.  

The European Commission this morning forecast that Greece would contract by 3.0% this year and another -0.5% next year.  The escalation of public protests in Greece clearly reflects that the country is not swallowing the bitter pill of austerity.  These conditions suggest it is probably impossible for Greece to achieve its dual aim of slashing its budget deficit and simultaneously meeting all of its debt obligations given the likelihood that yields will remain inflated for some time and that the EUR110 bln loan will last only 3 or so years.  The fact that Portugal and Spain had far lower levels of debt going into the economic climate suggests that their budgets have been better managed than Greece's.  That said given the risk of a default in Greece investors are in no mood to take chances.  If capital flight from Portugal's bond market continues it too could require an IMF loan.  Comments from the BBK's Weber this morning admit that there is a threat of grave contagion effects in the euro area.  The pressure on EMU officials to staunch the fear of default is great.  It is increasingly likely that if Greece is to remain in EMU it will almost certainly have to write off some of its debt, the question is who will take the haircut.  The sooner the EU officials answer this question the greater the chances of preserving EMU.  Against this backdrop the EUR has remained under pressure.  The EUR/USD1.2940 area has provided support this morning, but a move to EUR1.2700 ahead of an eventual move towards the long-term average rate of EUR1.18 is possible.  

Cable has also consolidated above USD1.5110 this morning in tune with EUR/USD.  Some opinion polls have suggests a more positive turnout for the Tory party at tomorrow's general election, but the consensus remains bias towards a hung parliament.  A squeeze higher in both sterling and gilts is likely if a majority government is elected given the greater chances that firm action will be taken on the deficit.  If a hung parliament is returned sterling will be vulnerable if coalition negotiations turn out to be protracted.  

US ADP employment data is due this afternoon.  ISM non-manufacturing data will also be released.  

 Jane FoleyResearch DirectorFOREX.comjfoley@forex.com+44 207 398 5024