It seems probable that yesterday's dive in US stocks was in part due to technical blip. That said, it cannot be denied that all assets classes have been displaying signs of nervousness this week. Fear of sovereign default and the need for substantial budget repair through the EMU, UK and the US will cloud the outlook for risk for some time to come. In terms of fiscal disrepair the worst positioned government remains Greece. Riots on the streets of Athens this week have demonstrated that there may not be the popular will to stomach further fiscal austerity. Insofar as there have been decades of popular distrust in the fiscal system, it is perhaps optimistic to assume that Greece can transform its government finances over next two or three years which, in term of budget reform, is a relatively short period of time. Once the IMF/EU loan for Greece runs out, it is thus still possible that Greece will default. ECB President Trichet yesterday distanced himself from the responsibilities of governments, suggesting that he was not about to bend ECB rules to accommodate Greece. The refusal of the ECB to start buying Greek government bonds can be explained by the fact that it would muddy the line between the ECB's mandate to control inflation and the fiscal responsibilities of the EMU sovereign states. Morally the ECB may be correct to refuse to take on the problems caused by a sovereign government. However, without further action from the ECB the risk of an escalation of the crisis within EMU will intensify. Market turbulence and continued contagion will increase the pressures on policymakers to ring fence Greece. If the credibility of EMU and the EUR is to be saved there may be no option but to admit that Greek debt will have to be restructured and the Greece may have to relinquish full EMU membership.
EUR/USD is trading off its lows this morning pushing up above USD1.2750 as the market calms down following the shocking scenes in US stock markets yesterday. However, the EUR remains very vulnerable. The coherence of EMU has been shaken and this suggests that the market will give up any notion that central banks will be diversifying away from USD reserves in the foreseeable future. This afternoon's NFP release has the capacity to add further comfort into the market (median +190), though the present climate suggests levels of volatility will remain high and the USD will likely benefit from this. USD/JPY has recovered some of its overnight losses. However, the bolstered yen also reflects diminished appetite for risk.
The UK officially has a hung parliament; the Tories won the most seats but not enough to form a majority. Constitutionally, the incumbent PM Brown could form a next government. However, insofar as Labour have fewer seats than the Conservatives this may be unworkable. The announcement this morning from Lib-Dem leader Clegg that the Tory party should be given the opportunity to form a government suggests that he may be willing to start coalition negotiations with the Tories and this did garner a positive reaction from the pound with cable pushing from USD1.4471 towards 1.4620 on that news. Coalition negotiations could last several days perhaps weeks and as demonstrated by the pressure on sterling overnight markets are likely to avoid GBP and gilts in this environment. The decision taken with respect to deficit repair will be the overwhelming factor for GBP and gilts for the rest of this year.
NFP will be keenly awaited today. Canadian labour data are also due. Over the weekend, UK coalition negotiations will be crucial for sterling with a quick decision likely to spark some buying pressure. German regional election could weaken the political position of Chancellor Merkel and could add to the pressure for governments to confront the fiscal crisis in Greece.
Jane FoleyResearch DirectorFOREX.firstname.lastname@example.org+44 207 398 5024