Greek debt crsis coming to the boil. Risk off the table but a little support for sterling.

The blowing out of the Greek-Bund 2 yr spread by over 118 bps this morning brings the debt financing crisis for the Greek government closer to boiling over. Having met its funding requirement for April, the Greek government may have few weeks to decide on its next step. That said, with every incremental increase in Greek bond yields a decision either to resort to the IMF for funding, to default on its debt or even to remove itself from EMU comes closer. Now that the EU has already played its hand, the options facing the Greek government have narrowed. Clearly last month's announcement of a support mechanism from the EU has failed to have the desired effect in cooling market nerves. It had been hoped that EU support would be enough to push yields on Greek debt down to levels at which the Greek government could afford to issue.

However, Germany has made clear that hand-outs are off the agenda and there is uncertainty how the EU support plan would operate in practice. With or without support from the EU the bottom line remains that after years of fiscal mis-management the market has little confidence that Greece can swallow the necessity austerity measures and slash its budget deficit. Investors continue to demand a growing risk premium to hold Greek paper and the government cannot afford to issue at these levels and simultaneously meet its deficit cutting targets. While renewed pressure on the EUR is evidence of the concerns of international players, domestic money has been fleeing the Greek banking system. As a result Greek banks have been forced to appeal to the government for help to counter the impact of money shifting out of the system. The Greek bond-bund 10 spread has moved back to levels not seen since ahead of EMU in 1999 and the risk of contagion to Portugal is growing. On the back of these concerns EUR/USD has hit a low of USD1.3284 this morning and pressure is likely to continue until the uncertainties surrounding Greek are resolved suggesting it could be a long and painful summer for the EUR.

Stock markets are lower and the yen is higher on the back of risk aversion stemming from Greece this morning. Weak US consumer credit data, soft Japanese machine orders numbers and the concerns of Fed President Bernanke about the large numbers of the long-term unemployed have also weighed on sentiment. The AUD pushed a little higher overnight on the back of good labour data, but risk appetite wilted at the start of the European session.

Cable has recovered from its poor start this morning on the back of much stronger than expected UK Fed industrial production data (+1.0% m/m). These numbers follow the publication of an OECD report suggesting that the UK economy may have the fastest expansion of all the large industrialised economies bar Canada in H1 2010. EUR/GBP has pushed lower, though this cross remains essentially range bound and sterling continues to suffer from fears of a post election hung parliament.

News that Treasury Secretary Giethner will travel to China this week has intensified speculation around a yuan revaluation. This afternoon's BoE and ECB policy meetings are not expected to bring any change in policy. Any questioning of ECB President Trichet on Greece may be the highlight. US initial claims data are due.

Jane Foley
Research Director