Comments from the IMF that Spain should do more to overhaul banking reform has been enough to heighten market tension about the degree of bad real estate debts in the Spanish financial system. The IMF also commented that the banking sector is sound. However, this is unlikely to negate market jitters. S&P has reportedly estimated that a Spanish state financial rescue plan may cost EUR 35 bln; an unwelcome development given that Spain is struggling to cast aside recessionary conditions (the EU has forecast Spanish growth at -0.4% this year). In contrast to Greece, the size of the Spanish economy is sizeable (it is Germany’s 8th largest export partner) and this explains the step up in sovereign insolvency fears.

Overnight US Treasury Secretary Geithner and Chinese Premier Wen Jiabao reportedly spent some time discussing the European debt crisis. That there is fear of contagion in the US can be directly linked with the fact that the US is mindful of its own fiscal short-comings. That said, the US’s status as safe haven means that its bond yields have been bid lower as a consequence of the crisis in Europe. This, and the fact that the US is likely to benefit from better growth that the Eurozone this year will buy the US some time before lack of fiscal discipline becomes a strait-jacket for the government. That said it is becoming increasing obvious to investors that the costs of the financial crisis on sovereign balances sheets have been huge and the overwhelming focus for the markets in the next year or so is how well each government can regain control of its finances. Investors will reward each market accordingly. 10 yr t-notes are yielding 3.07% this morning, 10 yr Bund yields have been pushed down to 2.57% as investors search for safe haven. Spanish, Greece, Portuguese and Irish 10 yr bond spreads vs Germany have widened again today.

The USD and the yen can be expected to remain well bid in the current nervous market environment. Cable has pushed lower again this morning, though it has stabilised in the USD1.4260 level. Sterling has fared better against the troubled EUR edging back below the 21 day sma which is suggestive of a more encouraging outlook for the pound. Q1 GDP was revised higher to +0.3% q/q, in line with expectations on the back of a 1.2% q/q surge in manufacturing. Sterling found a little support from this data. Yesterday’s commitment by the new government to make GBP 6.2 bln has also been a constructive development for the UK economy. However, with the budget deficit standing at GBP 163 bln, there is much more to be down. Today’s Queen’s speech will outline the intentions of the coalition and will likely strengthen the commitment of the government to fiscal repair. EUR/GBP 0.8400 remains key support.

Any more news on the French and Italian budgets will be of interest this afternoon. US housing data, Richmond Fed Manu index and consumer confidence data are due.