Forex Market Update

The primary cause for the problems in Greece, Portugal and Spain relate to poor competiveness.  Since EU membership prevents this being addressed with a currency devaluation, budget reform (which should translate into cheaper wages) is the path that is being promoted.  However, scepticism about the ability of Greece to fully swallow the austerity pill is widespread.  It has been clear for some time that if Greece and other EMU countries cannot compete with Germany then Germany and her more competitive neighbours have little option to step up the pace of fiscal transfers to maintain coherence within the EMU.  The EUR 750 bln package thrashed out by the EU officials over the weekend could thus be seen as the start of closer fiscal ties within the EMU.  There is, however, a massive stumbling block to this insofar it implies a reduction of autonomy from member Sovereign states over fiscal policy.  Judging by the results of Sunday's German regional election, Germans are in no mood to hand over to the EU increased power to decide where their taxes go.  On the assumption that Europe is not ready to move closer to a federal system, the risk that Greece must be allowed to default at some stage or leave the EMU still remains.  The hurdles facing the Eurozone remain numerous and EUR/USD is likely to continue edging towards its long term average at EUR/USD1.18 and potentially below.  

Still there is no government in the UK.  Politically PM Brown played his last card well by offering his resignation in return for coalition negotiations between his Labour party and the LibDems.  However, insofar as the Labour and LibDem together still cannot muster a parliamentary majority, additional support would be needed which increases the chances of a weak coalition government. This suggests sterling could be confronted with more headwinds going forward with respect to the budget deficit.  That said, positive UK Mar production data this morning (IP 2.0% y/y) strengthens the view that the economy is pulling further away from recessionary conditions.  Insofar as better economic conditions will aid the ability of any government to tackle the deficit is still likely that cable has printed its lows for the year.  EUR/GBP remains choppy.  Despite the present UK political uncertainty, the likely escalation of EMU issues suggests EUR/GBP should maintain a medium-term downward bias.  

Fears of further Chinese monetary tightening have intensify the move back out of risk this morning; stock indices are lower across the board, Brent futures hit an intraday low of $78.89 /barrel and EUR/JPY dropped to 117.00.  Coincident with the move away from risk AUD/USD eased lower from overnight levels.  Australian Treasurer Swan presented a prudent budget overnight with the government pledging to keep a 2% cap on spending growth until the budget surplus (currently in the region of -4% of GDP) reached 1% of GDP.  Given current market fears with respect to sovereign deficits and default, well managed fiscal policy is likely to enhance demand for AUDs going forward.  Dips in AUD/EUR could present buying opportunities.  

US wholesale inventories, IBD/Tipp economic Optimism and ABC confidence data are due this afternoon.

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