WISE MONEY

A new shockwave filtered through the markets on Friday as the credit agency Standard & Poors (S&P)- downgraded France, stripping them of its prized AAA rating. The decision to remove this vital asset in keeping borrowing costs to a minimum left France with a AA+ rating, a judgment that will likely cost billions in higher repayment costs.

S&P said “Europe’s austerity and budget discipline alone were not sufficient to fight the debt crisis and may become self defeating”.

Alongside France, S&P cut the rating of Italy, Spain, Cyprus, Portugal, Austria, Slovakia, Slovenia and Malta though it was expected that these countries would have their ratings lowered.

Overall, the picture isn’t looking good for Europe and with further downgrades likely over the next few months, it will be important to see how the ECB reacts in keeping this ongoing debt crisis under control.

The main winner from this continues to be the US Dollar with further gains against most currencies likely as investors pile more money into the global reserve currency.

For as long as the Greenback keeps this status, it will remain the market leader in these testing times as Europe sits on a knife edge between growth and recession.

There is very little data out today with the only comment of note coming from a speech by ECB President Mario Draghi due at 6pm UK Time.

It is likely he will focus on the downgrade on France and how the ECB will look to repair the damage it has caused.

The euro debt crisis has taken a back seat today with no comments or figures coming from the Eurozone. Maybe it’s because the various European politicians are following the draw of their premier sporting event, the Champions League and have taken the day off. Or maybe it is down to there being no news or progress with sorting out the future of the single currency.

The relationship between Britain and France took a hit yesterday as French Central Bank chief Christian Noyer lashed out at the UK’s economy saying “Britain should be downgraded before any cut to France’s credit rating”.

Prime Minster David Cameron responded by pointing out the UK’s low bond yields and the credible plan in place to cut the mammoth annual deficit.

This aside, the markets are very calm as we finish the week. The US has some inflation figures due out in the form of CPI data as well as some FED members speaking, but these will bring little in the way of movement.

The Greenback has remained strong as invested move funds into the only currency being viewed as a “safe haven” and this will likely continue into the new year as no additional risk will be wanted over the holidays.

Compare and contrast: the interest rate on the three month note issues by the Spanish yesterday was 5.11%, the interest rate on the US equivalent was 0.01%. Spanish borrowing costs jumped from last month’s auction partly because we are in between governments and the incoming party is still unsure if it will be able to pass the necessary austerity measures to (hopefully) reassure the markets but also because eurozone sovereign debt markets are now completely dysfunctional.

The Euro, after a bit of a rebound yesterday, has opened today on the back foot because of the Spanish problems yesterday and also due to a story overnight about the potential renegotiation of the bail-out of Dexia Bank.

Chinese PMI was also lower than consensus estimates and risk sentiment, which has been falling over the past week, will be further reduced and that means US Dollar strength, Euro and GBP weakness and stock markets continuing to fall.

The Federal Reserve minutes from last months meeting were released last night, and in light of the US GDP revision downward yesterday afternoon were surprisingly neutral in tone.

Only one member, Chicago president Charles Evans, voted in favour of QE3 with several unnamed members suggesting further action may be warranted.

The mere fact that further easing was not ruled out was enough to produce a bounce in US equity markets before normal service was resumed in the asian session.

The Bank of England will follow their Central Bank compatriots in the US by releasing their own minutes from this months meeting.

Again the market will be looking for signs of further monetary stimulus early next month.

Usually tight fiscal and loose monetary policy translates into a weak currency, but Sterling has remained fairly steady over the last year.

The size of any further QE will  be an important factor in whether Sterling stays within or breaks out of it recent range.

A vote in Germany to sanction a measure for a debt-stricken country to leave the single European currency could open can of worms and could be detrimental to euro sentiment. There are several data releases on tap today that will provide some short term influence on the Euro, including Q3 GDP and the November German ZEW survey.

Investors will likely pay no attention to an encouraging reading for GDP given the negative outlook for Q4. The forward looking ZEW survey will record a further drop highlighting the risks to Europe’s biggest economy.

Spanish and Greek bond auctions may gain even more attention in the next few weeks.

This is following on from yesterday’s Italian debt sale in which the yield on 5-year bond came in higher than the prior auction but with a stronger bid/cover ratio, markets will look for some positives from today’s auctions.

Even if the auctions go well, on balance, relatively downbeat data releases will play negatively for the euro.

When viewing the euro against what is implied by interest rate differentials it is very evident that the currency is much stronger than it should be at least on this measure.

Both short term and long term yield differentials between the eurozone and the US reveal that EUR/USD is destined for a fall.

Europe’s yield advantage has narrowed sharply over recent months yet the euro has not weakened.

Some of this has been due to underlying demand for European portfolio assets and official buying of Euro from central banks but the reality is that the Euro is looking increasingly susceptible to a fall.

EUR/USD is poised for a drop below the psychologically important level of 1.35, with support seen around 1.3484.

The European Central Bank looks to be facing a ticking time bomb as the cost of Italian debt shot through the roof yesterday.This left markets in free fall with the Dow Jones in particular dropping 3.2% leaving the eurozone facing its biggest economic ‘problem child’ to date.

On paper Italy looks too big to rescue yet is too big to fail.

The Italian’s have nearly €2 trillion in debt and is the third largest country in the eurozone and therefore it cannot be as easily dealt with as Greece.

Italy is required to raise €19 billion every month to meet its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable.

Higher collateral haircuts on Italian debt are adding to the pressure.

Even though Italian PM Silvio Berlusconi has promised to step down following votes on austerity measures this may not lead to a sharp exit as this may not take place for weeks.

Furthermore, Berlusconi may try to re-obtain power after stepping down, which effectively brings us back to square one.

Meanwhile the prospect of Italy becoming the next country to need to a bailout will intensify.

This could lead to liquidity issues with only around €270 billion left in the EFSF bailout fund and the mechanics of how the fund will be leveraged to a planned €1 trillion is still uncertain.

This has lead to press reports that the major power houses of Germany and France have started talks to break up the eurozone due to worries that Italy will be too big to rescue will only add to a downward spiral on this story.

Under the spotlight today will be the 12 month auction of €5 billion in Italy.

Back in October the 12 month auction were sold at an average yield of 3.57% however this time we could see this rise above 6%.

What is most concerning is that it appears that even with the ECB buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s lack of enthusiasm to become the last resort lender to European peripherals, any further support from this direction will be limited.

Based on this the single European currency looks highly susceptible to further losses and we could see the EUR/USD drop through 1.35.

Italian President Giorgio Napolitano announced last night that under attack Prime Minister Silvio Berlusconi will step down once new austerity measures are passed. The Italian government successfully passed a finance bill yesterday, but only after the opposition Democratic Party abstained.

This led to Berlusconi losing his majority triggering calls for his departure.

The Euro initially strengthened on the back of this as the “Bunga Bunga” PM’s leadership failed to reform Italy’s public finances and slow economy.

The new austerity measures are expected to be passed by the end of November at which point he is expected to resign.

Once the initial Euphoria of the news from Italy, the euro started weakening again as the consensus is that the euro crisis is far from over.

The bond yields, which are the easiest way of assessing confidence in an economy peaked at 6.77 per cent, creeping ever closer to the significant 7 per cent level.

This level was where Portugal and Ireland were forced to seek bailouts as they could not support their debts.

As Italian bonds total €2 trillion, which is considerably greater than Portugal, Ireland and Greece combined; the threat of a default is hanging over the markets.

The future of the Euro is hanging by a thread and the impact of these pending austerity cuts from Italy is key to what happens next.

Italian Prime Minister Silvio Berlusconi was reportedly on the brink of resignation yesterday, which he swiftly denied, using the unusual political channel of Facebook. The news pushed yields on the benchmark Italian bonds towards the sort of levels that spelt the end for Portugal, Ireland and Greece.

Mr Berlusconi’s critics want him to move aside and appoint Mario Monti, an economist and technocrat to lead an interim government made up of external experts and some serving minsters that will carry out the reforms that the Berlusconi government has promised but failed so far to deliver.

The news pushed the Euro lower against the Pound and Dollar and continued the trend of Euro weakness set in motion by the ECB rate cut last week.

Pressure is mounting on the ECB to resume purchasing Italian bonds before the situation gets any worse.

The key Sterling release this week will be the Bank of England meeting on Thursday, with further QE the main talking point.

The consensus is for the Bank to leave asset purchases alone for this month, using their wait and see strategy to assess whether to increase gilt purchases next month or early next year if the economic situation continues to deteriorate.

Speaking of which, this morning industrial and manufacturing production data should show a small increase month on month, but the overall picture will probably remain disappointing and point towards further monetary stimulus to come.

Eurozone finance ministers are meeting to discuss the region’s debt crisis in the first of several summits to be held in Brussels over the weekend.On Saturday, ministers from all 27 EU countries will hold talks. EU leaders will then gather on Sunday and at an extra meeting on Wednesday.

They need to agree a second bailout for Greece, how to recapitalise banks, and a stronger bailout fund, before Greece can then be allowed to default- and there still appear to be deep divides between France and Germany.

In particular, the two need to agree on how to increase the firepower of the eurozone’s bailout fund, the European Financial Stability Facility (EFSF), from its current 440billion euros ( £383 billion).

France has proposed turning the EFSF into a bank so that it could borrow from the European Central Bank (ECB), but Germany has refused to sanction such a move, arguing it would compromise the ECB’s impartiality.

The German government has also promised its taxpayers that its contribution will not go above 211bn euros so is looking for a way to increase the size of the fund without increasing the liabilities of German taxpayers.

Despite no apparent movement on the deadlock, markets were trading higher, with the leading indexes in London, Frankfurt and Berlin all up between 1.5% and 2.7%, while US markets also rose at the start.

Jean-Claude Juncker, the chairman of the eurogroup and the prime minister of Luxembourg, said the delay to a deal portrayed a “disastrous” image of the eurozone to the rest of the world, adding that it was not necessarily just France and Germany that had differences of opinion.

This crisis has underlined that the EU, in large part, remains a Franco-German union. The other members of the eurozone appear as bystanders whilst the French and German leaders determine the fate of their currency.

A deal on the euro had been expected to be signed on Sunday, but France and Germany said they would not be able to reach an agreement by then and announced that leaders would meet again on Wednesday.

Sunday’s summit had already been delayed from 17-18 October because more time was needed to finalise a plan.

A second hurdle in the way of any rescue plan is that negotiations have not yet begun properly with private sector lenders to Greece on a further reduction of what the Greek government will repay them.

Banks have already agreed to take a 21% loss, or “haircut”, on their loans to Greece but there is growing pressure for them to accept higher losses.

Previous disagreements between France and Germany about the bailout plans have centred on how much the private sector would have to contribute to any package.

A QE3 could still be launched according to the Federal Reserve minutes released last night, with two on the ten strong FOMC committee suggesting the current US economic outlook could justify stronger policy action. Operation twist is aimed at keeping down long term interest rates by selling shorter term notes to buy longer dated maturities, but how successful this policy will be at keeping the economic recovery going is unclear at this stage.

Which is why the much more potent QE3 is being kept in the wings should we see another deterioration in outlook.

The news has gone some way in tempering the recent Dollar strength we have seen against Sterling and the Euro alongside investors regaining their risk appetite over the past few days.

Bank recapitalisations in Europe are fast becoming the new battle front between the banks and governments, with the head of Deutsche Bank saying the lender will do everything in its power to avoid a forced recapitalisation.

Interestingly Mr Akerman suggested that pressure from governments to hold eurozone bonds had cost the bank close to €400 million this year alone.

The Euro continues its tear higher on the back of higher than expected German CPI this morning, the ECB is heavily influenced by the German inflation hawks and so if inflation continues to climb over Europe the probability of the ECB cutting rates begins to fall.

Disappointing unemployment figures yesterday in the UK had surprisingly little impact against the Dollar and Euro.

The number is extremely worrying, given jobs are the lifeblood of the economy, and lend weight to the Bank of England’s thinking over further QE.

We can expect the jobs situation of get worse before it gets better – especially in light of the looming government cuts ramping up next year.

The money markets were calm in yesterday’s trading day as traders and investors alike attempted to interpret the rumours surrounding a Eurozone bailout package that started over the weekend.Stories have been popping up about a €1.7 trillion fund which would be aimed at saving the Eurozone and allow Greece to default on its £340bn debt pile.

This would involve propping up the banks that have invested in Greek bonds so that a controlled bailout can begin on the ailing country.

Further plans involve recapitalising Europe with tens of billions of Euros to reassure the markets.

UK Chancellor George Osbourne was forced to issue a hastily drafted statement after a British Treasury official outlined behind-the-scenes moves allowing a Greek default.

His comments insisted that Greece does have a recovery plan and must carry it out as he rejected claims that the G20 would allow a default.

The markets reacted with the Euro taking a small hit across the board, but also the US Dollar as some investors hastily moved funds from the so-called “safe haven” other  instruments.

Little volatility has occurred since then as everyone waits for any more news/rumours surrounding the main story of the moment.

The likelihood of Greece being able to follow its current plan and rebuild its economy seems unlikely and some sort of default or write down of their debt seems inevitable.