If a gauge is needed to measure how concerned investors are at present about sovereign default risk, we need look no further than the price of gold which is making fresh all time highs this morning ($1244.10 /oz).  Assets with intrinsic value are in demand.  US treasury debt has also fared well on the back of safe haven demand over recent weeks with 2 yr yields dropping by 12bps this month; the USD could be entering in a renewed period of broad based strength as a consequence of the fiscal cracks within the Eurozone.  However, this has not prevented the US authorities being wary about the risk of contagion from the European fiscal crisis;  after all the US budget deficit may hit 11% of GDP this year which is not too far behind that of Greece (at 13.6%).  Clearly the Greek crisis has shaken both investors and governments across the board.  Over the next few weeks the markets will find out how worried the new UK government is about its massive 11.5% of GDP budget deficit and whether it has the cohesion to tackle it.  In recent weeks investors have been reluctant to significantly extend sterling shorts.  Even though it took 5 days to form a new government following last week's election the BoE's effective sterling index yesterday (79.48) traded just a smidgeon below the average of last week's levels (79.64) and almost 4% above the March low.  It seems that investors have been giving the UK government the benefit of the doubt with respect to deficit reduction.  That said sterling could be a harsh critic of government if it fails to deliver on budget reform.  The initial signs are good with the LibDem's Vince Cable reversing his previous rhetoric that deficit reduction had to wait until the recovery was more firmly established.  A budget is expected in 50 days; further signs that the government is positioning itself to tackle the task in hand could see EUR/GBP pushing back towards the 0.800 level on a 3 mth view.  Technically, the primary target is 0.8400, a break below may see towards 0.8335.  

The Bank of England's Quarterly Review has been taken poorly by the pound with EUR/GBP stepping higher towards EUR0.8505 and cable dropping back to USD1.4918 after a positive start to the London session.  The overwhelming theme of King's speech was the need to tackle the budget deficit sooner rather than later.  King's words that we are only a part way through the financial crisis are a sobering reminder that the return to health of government balance sheets will be an overriding theme for both UK and global markets in the coming years.  

Better than expected growth data from Germany this morning (0.2% q/q) will help relieve a little of the tension surrounding the EUR (EUR/USD touched an intraday high of 1.2799 this morning). However, it does not change the likelihood that the peripheral countries such as Greece, Spain and Portugal could continue to grapple with recessionary conditions well into next year; a scenario which will reinforce the difficulties of budget reform.  The Spanish economy in Q1 managed to grow a modest +0.1% q/q though prospects for expansion going forward will be undermined by this morning's announcement from the government that it will aim to cut the budget deficit a further 1.5% to 6% of GDP in 2012; measures include cuts in public sector pay.   Today's Spanish budget is a positive step towards a return to fiscal health in the Eurozone.  That said with Spanish unemployment already at 20% there are no guarantees that Spain can fulfil its austerity pledges.  The market fully understands that the weekend's EU support package for Greece was a far cry from an overriding solution to the lack of fiscal coherence and control in the Eurozone.  The enormity of the fiscal issues to be overcome in EMU suggests that the EUR is likely to be shunned by long-term investors for some months yet.  EUR/USD may be headed to its long-term average of 1.18 and potentially below.  

US and Canadian trade data are due this afternoon.  

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