EMU fears encompass Italy. Further UK budget gloom decends.
Greek-bund yield spreads have widened further this morning reflecting widespread unease about the situation in the EMU. Chancellor Merkel has condemned any part that investment banks may have taken to help hide the full extent of Greece's budget deficit prior to EMU entry by helping Greece to raise funds through derivatives operations. She has also threatened that not a single extra EUR of EU taxpayers money should go to Greece. Complicating matters further have been fears that Italian municipalities may have significant derivatives exposure which has dragged Italy's government budget under the spotlight. While Italy appeared to be running a healthy primary surplus in the years ahead of EMU its huge public debt points to years of poor fiscal management. Whether or not its budget was enhanced by the use of derivative operations does need to be clarified. Meanwhile with further strikes planned to hit Greece it still looks nigh on impossible to expect that Greece can shrink its budget deficit to 3% of GDP from 12.7% last year by the end of 2012. Such drastic action would entail large cuts in public sector wages and a sharp rise in unemployment. With Greece's options looking limited a potential exit from EMU and a devaluation in its currency must be entertained as a possible scenario since the competitive boost this would provide would lessen the need for a slashing in wage costs. It could be that this would eventually strengthen a re-configured EUR, though in the near-term uncertainty about what may happen is likely to lead to further pressure on the EUR. Despite the uncertainties over EMU, EUR/USD has bounced off the 1.3450 level this morning. However, the break below the USD1.3585 area suggests the EUR may see towards 1.3420.

Strengthening the losses in EUR/USD in Asian hours was the announcement from the IMF that it would start to sell around 200 tons of gold in the open market. Gold prices immediately tumbled by $10 /ounce on the ounce pulling the USD to stronger levels. Gold has since recovered from the day's lows which has given way to this morning's bounce in EUR/USD.

Cable suffered more bad news this morning in the form of a horrible set of UK public sector borrowing data. The market had been expected a net inflow into the government's coffers in Jan consistent with the seasonal pattern that has held since this system of accounts was adopted in 1993. However, for the first time the Jan net borrowing data registered a deficit (of GBP4.3 bln). This reflects in part the far worse than expected January labour market data released yesterday. More shockingly it suggests that the UK may be on track for notching up a budget deficit/GDP ratio larger than that of Greece this year. Cable has remained clear of the key GBP1.5540 support level this morning, a break below could lead to a leg lower for the pound.

As expected the BoJ left policy unchanged at this morning's meeting, allowing the JPY to strengthen a touch. The BoJ did state that beating deflation is a critical challenge. This suggests that further policy measures from the BoJ may be in the offing in the months ahead. For now the fact that the JPY is well off last year's highs vs the USD has removed some of the pressure to take further policy action.

Gold's fall overnight impacted AUD/USD. However, the aussie has managed to reverse some losses.
This afternoon Canadian CPI, US PPI, initial claims, Philly Fed and leading indicators are due.
Jane Foley
Research Director