Mkt looking to Germany to pull rabbit out of hat for Greece.
BoE promotes dovsih view.

The market wants to hear detail on whether or what Germany may offer Greece in terms of support. EUR/USD has traded with a modest upside bias in European hours on hope that Greece's problems are closer to a resolution and after solid Chinese trade data lifted risk appetite in Asia. However, under the current Commission rules it is difficult to imagine that German can pull a rabbit out of the hat quickly. Meanwhile public sector strikes have total brought Greece almost to a standstill today, serving as a reminder of the depth of the issues that are faced.

Under current rules the European Commission can ultimately impose financial sanctions on a country that fails to bring its budget deficit back in line. The rules appear inadequate but are unsurprising when it is considered that there is no fiscal union implied by EMU. Clearly the imposition of financial sanctions would not help Greece's budget position and could turn public support within Greece against EMU. There are no procedures in place within the EMU which would allow a bail-out from one country to another. The reasons are clear. A monetary handout would lessen the incentive of the Greek electorate to tolerate budget reform or enforce tax collection. Also, suggesting to the German tax payer that he subsidises a nation were taxes are habitually not paid would also not be a prudent step for a German politician to take. That said there is a lot of political will invested within EMU and not to support Greece would be to risk further contagion which would pressure the banking sector, potentially undermine the cohesion of EMU, and maybe even trigger a collapse. Some kind of carrot/stick support plan is likely to be put in place for Greece. However, it is not clear whether EMU lawmakers will be able to hammer this out quickly. Any delay in coming up with a solution would risk further downside pressure on the EUR.

Cable suffered on the release of a dovish BoE's Inflation Report this morning. In line with market speculation, the outlook for GDP has been revised lower. In contrast to market speculation CPI has also been revised down. Governor King acknowledged that Jan CPI was likely to rise above 3% in response to base effects but projected that CPI would be below the 2% target by the end of the forecast period. On growth King said that downside risk are less than they were, but conceded that output was unlikely to return to trend for a considerable period and throughout the forecast period. This has raised questions as to why the BoE did not extend QE this month. However, this may be related to the view that with the banking sector mostly recovered from crisis, QE is not the most effective policy to support the real economy. GBP/USD had earlier in the session benefitted from better than expected UK Dec production data which raised hopes for an upward revision to Q4 GDP. On the release of the Inflation Report cable has retreated to the USD1.5660 area and EUR/GBP has surged to 0.8820.

The JPY has softened modestly this morning in tune with the cautious optimism in the market. However, news from Germany on Greece is keenly awaited. Other key focus today is Bernanke's testimony of the Fed's exit policy (if weather allows). US and Canadian Dec trade balances are due.
Jane Foley
Research Director