The 3.9% contraction in the S&P yesterday is further hard hitting evidence that the market was indiscriminately unloading risk amid elevated levels of anxiety.  Even though European stock indices have managed a mixed open and the EUR and risky asset such as oil and the AUD are trading off their overnight lows, markets remain clearly worried.

Weaker than expected German PMI data this morning (at 58.3 for the manufacturing component down from 61.5 in April) and the softer expectations component of the May IFO (down to 103.7 from 104.0 in April) provide further signs that the fiscal crisis in the Eurozone is impacting confidence in the real economy.  This is another negative factor for the EUR, though the overwhelming negative case against the EUR surrounds the uncertainties over fiscal coherence.  It seems sensible that the EU will eventually accept rules tightening the Stability Pact.  However, with Germany having no will to keep bankrolling less prudent members of EMU, a procedure that would allow for sovereign insolvency within EMU should also be written into EMU.   Given the negotiating hurdles faced by EU officials and the fear that some debt holders are facing default, the EUR is still likely to fall below the key EUR/USD1.2135 support level in the coming weeks.

Crucially the market is becoming increasing sensitive to signs that slower growth in Europe is spreading outside its borders.  There is increased speculation that the Chinese authorities will hold off from any revaluation of its exchange rate amid fears that European growth will remains sluggish.  This conclusion should not be too surprising given that Chinese authorities have been consistent in their view that any decision to revalue will depend on the recovery in its biggest export markets.  More surprising is the degree to which the issues in Europe are impacting confidence in US markets.  US data has been relatively good recently resulting in the FOMC revising up its forecast for growth from 3.25% in 2010 to 3.45%.  Despite this backdrop the market was rattled yesterday because weekly initial claims data were worse than expected.  Weekly data almost by definition are erratic.  Besides, it is natural for the number of job seekers to increase in the early months of an economic recovery as confidence increases that job opportunities do exist.  That said the US does face a huge fiscal squeeze which is likely to start impacting next year.  While US growth will likely outpace that of the UK and EMU in 2011, finally the market is accepting the view that the fiscal repair process in the industrial world will keep a lid on economic growth.  This view is resulting in a re-pricing of risky assets.  The USD will continue to do well in this environment.  Oil could see $60 /b and potentially below on a 3 mth view.  AUD and CAD and NZD can be expected to remain on the back foot vs the USD, though they may perform better on the EUR crosses.  Talk of RBA intervention last night lent support to AUD/USD.  On the charts a double top in AUD/USD suggests that a deep correction is underway.

Sterling's move over the 21 hr sma yesterday is a bearish technical signal for the pound.  The market has not taken kindly to fears that the new UK government could reveal that the budget deficit is worse than expected.  Today's PSNCR data for April was worse than expected at GBP8.6 bln.  The Treasury has reacted by stressing the needs for action on the deficit.  The budget on June 22 will provide more detail but the Queen's speech next week will provide some direction particularly with respect to the GBP 6 bln planned savings this year.  Sterling will be vulnerable on the uncertainty connected with the budget but will be rewarded by investors if the government does show resolve in tackling the issue.  Strong support at EUR/GBP 0.8400. Soft growth in M4 suggests that the QE program has not had much impact on the real economy.  

Canadian CPI and retail sales are due today. Jane FoleyResearch 207 398 5024