Economic data and corporate earnings are all taking a back seat today as global debt issues dominate the markets. The Republicans are now fighting amongst themselves over raising the debt ceiling and with only 4 days to go before the US reaches its credit limit this issue is going to the wire. So what are the FX markets doing today?

  •  The euro is lower after Moody's announced it was putting Spain on review for possible downgrade. One of its justifications for doing so was the stress caused by Madrid providing extra funds to the second Greek bailout. This is another way of looking at contagion.... EURUSD nose-dived and is below the 1.4330 pivot point. We think the pair could be volatile today. The Eurozone's CPI estimate for July is released at 1000 BST, which may focus minds on the ECB's pledge to target inflation, and if the US debt crisis continues to deteriorate it suggests the dollar may suffer. So expect a rocky road ahead.
  •  The Aussie and the Kiwi are also lower, along with the Swissie, even the yen has weakened slightly. This is mostly down to a dollar move. The dollar index is up more than 1.3% in the past two days. We continue to think that the pacific currencies along with the safe havens will remain in demand over the coming days as the US debt ceiling deadline gets closer, and some investors may see this sell-off as an opportunity to go long.
  •  The pound is weaker along with the euro. This is an interesting development since there has been a divergence between the UK's FX and credit markets. Gilts have been attracting safe haven flows of late and out-performing US Treasuries, while the pound has come under pressure against the dollar. GBPUSD is vulnerable to volatility as investors go hot and cold on the pound right now - one minute its growth fears that weigh on the pound, the next the pound gets boosted from a weak dollar. However, sterling shows its real colours against the Swissie and the Aussie. Versus these two strong currencies the pound is close to record lows.
  •  The UK's Gilt market is acting like a safe haven while the political stalemate thwarts a resolution to the debt ceiling crisis in the US. The Gilt market is extremely liquid, and even though the UK is also struggling with its debts, at least it has a plan to reduce its fiscal deficit during this parliament. Reports suggest that large holders of Treasuries may be moving into the UK debt market just in case the US defaults in the coming weeks, or gets downgraded.

The chart below shows the spread between US 10-year bond yields and UK 10-years (white line), US 2-years and UK 2-years (orange line) and US 30 years and UK 30 years (yellow line). As you can see, the spreads are all moving higher as US yields rise at a faster pace than UK yields. This suggests there is selling pressure in the US market. This is especially notable in the 2-year spread (orange line on chart). Although this spread is negative and UK yields are higher than US yields, the difference has narrowed sharply in recent days, and since short-term bonds are usually the most volatile this suggests that credit market investors' have become more worried about near-term fiscal conditions in the US.

It's worth keeping an eye on what spreads are doing as sentiment in the credit markets have been seeping through to other markets such as equities and of course, currencies, making conditions extremely volatile as we head into the weekend.

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Kathleen Brooks| Research Director UK EMEA |

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