WISE MONEY

The UK’s Consumer Price Inflation rose by 3.2% year on year in June 2010 compared to 3.4% in May, more than the 3.1% average forecast by analysts.

The widely used Retail Price Inflation decelerated to 5.0% in June compared to 5.1% in May. RPI-X also slowed from 5.1% in May to 5.0% in June. However, core inflation accelerated from 2.9% in May to 3.1% in June, which matched the highest reading since 1997.

According to the Office for National Statistics, the biggest downward pressure to CPI inflation between May and June came from falling energy (petrol and diesel) prices. Another significant downward contribution came from clothing and footwear, where prices fell due to the June sales season.

The latest inflation data will boost the case by Andrew Sentance who is the sole member of the MPC who is looking for a gradual interest rate rise and said the path to economic recovery could be uneven but that did not equate to a risk of a double-dip recession. “I favour a gradual rise in Bank Rate which would be aimed to avoid destabilising confidence through a sudden lurch in policy.”

Sterling reacted well against the US Dollar and moved up to above the 1.52 levels at the close of play from opening at 1.4996.

In European news yesterday, the rating agency Moody’s downgraded Portugal’s debt rating by two notches to A1 from its previous AA2 rating, with a stable outlook. Moody’s explained the downgrade with the ongoing deterioration in the debt ratio as well as the dim medium-term growth outlook.

Markets showed little reaction to the news, probably because Moody’s initially placed Portugal on credit watch in May 2010.

The euro held steady against the dollar after a smooth Greek Treasury bill auction eased some concerns about Europe’s debt crisis, this helped take the sting out of Portugal’s expected credit rating downgrade and disappointing German Zew index.

The pound strengthened to 1.22 against the Euro yesterday for the first time since November 2008.

Sterling continues to benefit from the UK budget announced earlier this week and the news that one MPC member voted for a rate hike this month. A strong response from the credit agencies took away fears that the UK’s AAA rating could be downgraded.

Concerns over the European debt crisis were on the rise again yesterday with Greek credit default swaps hitting a record high.

ECB president Trichet said he is “pleased” with Germany’s decision to concentrate on fiscal discipline, he also commented that the idea that austerity measures could trigger economic stagnation is “incorrect” and he does not think the risks around deflation will materialise.

Another cause for concern in the Eurozone is the requirement for European banks to repay the $540bn of ‘special’ 1-year loans that they borrowed from the ECB.

The added problem here is that a number of the banks used the loans to buy up bonds in Greece, Spain and Portugal – fixing in a healthy interest margin in the process. Now they have to repay their ECB loans, the banks may decide to offload some of these bonds, which could reignite tensions in European financial markets.

Investor George Soros has warned Germany to leave the euro unless it is willing to embrace a growth strategy, calling Berlin’s current austerity plans  a threat to democracy and political stability in Europe.
“German policy is becoming a danger that could destroy the European Project. A collapse of the euro cannot be excluded,” he told the German weekly Die Zeit.

“Unless Germany changes policy, its withdrawal from the currency union would be helpful for the rest of Europe. At the moment Germany is pushing its neighbours into deflation: this threatens a long phase of stagnation, leading to nationalism, social unrest, and zenophobia. It endangers democracy,” he said.

Mr Soros saw the political effects of wage cuts first-hand during the Great Depression, and narrowly survived the Holocaust as a Jewish boy in Nazi-controlled Budapest. He has since dedicated much of his wealth to philanthropic works promoting freedom and pluralism across the globe, mostly through Open Society institutes.

His comments reflect growing alarm in influential circles on both sides of the Atlantic over the 1930s-style policies of wage cuts and debt-deflation being imposed up the Club Med bloc, Ireland, and parts of Eastern Europe by the EU authorities, at the behest of Berlin.

President Barack Obama clearly had Germany in mind when he wrote a letter to fellow leaders before the G20 summit in Canada this week that surplus countries should do more to shore up global demand. “Our highest priority must be to safeguard and strengthen the recovery: we cannot let it falter or lose strength now. Should confidence in the strength of our recoveries diminish, we should be prepared to respond again as quickly and as forcefully as needed,” he wrote.

China has deflected G20 criticism by starting to free the yuan, leaving Germany facing the full wrath of Washington.

While the German economy is not in itself large enough to shape global events, US officials fear that Berlin’s dominant influence over the European Central Bank and the fiscal machinery of monetary union is dragging most of Europe into an economic swamp. Germany has raised the bar for every eurozone country by announcing €80bn of belt-tightening from next year.

Nobel laureate Paul Krugman told the German press earlier this week that the country was committing the same error as the United States in 1936-1937, or Japan in the 1990s, by withdrawing stimulus before recovery has taken root.

“I don’t have a problem with trying to balance the budget in five or 10 years. The question is whether one should start when the economy is at 7 or 8 percent below its normal capacity and interest rates are at zero. Now is not the time to be worried about deficits.”

Professor Krugman said there was a risk of a “domino effect” reaching Spain and Italy if Bundesbank chief Axel Weber takes over as head of the ECB and fails to offer enough monetary stimulus to keep these countries afloat.

One analyst said that Mr Weber faces an impossible task. “Either they do more QE (quantitative easing), in which case it will set off inflation in Germany and cause Germany to leave EMU: or they don’t do more QE, in which case it will lead to deflation in Southern Europe and force them out of EMU,” he said.

Mr Soros said Germany was treating the deeply-flawed Maastricht Treaty as it were a “sacred text”, warning that monetary union cannot endure for long as a narrow construct based on debt and deficit ceilings.

He said wage rises in Germany are imperative to help lift the whole eurozone, allowing peripheral economies to claw their way out of trouble without fighting the extra headwinds of deflation.

“The truth is that what we have in Europe is not a currency or sovereign debt crisis as many people think, but a banking crisis,” he said.Mr Soros argued that the weaker states cannot easily fund their deficits any longer because some banks are purchasing fewer bonds as a result of damaged balance sheets.

Analysts at the French financial group AXA see a serious likelihood that the eurozone will break in half or disintegrate, dismissing Europe’s £623bn rescue package for Club Med debtors as a stop gap measure that misdiagnoses the problem.
“The markets are very nervous because they can see that there is a fatal flaw in the system and no clear way out,” said Theodora Zemek, head of global fixed income at AXA Investment Managers.

“We are in a very major crisis that has even broader implications than the credit crisis two years ago. The politicians have not yet twigged to this.”

Ms Zemek said the rescue had bought a “maximum” of 18 months respite before deeper structural damage hits home, with a “probable” default by Greece setting off a chain reaction across Southern Europe.

“It would be the end of the euro as we know it. The long-term implications are at best a split in the eurozone, at worst the destruction of the euro. It is not going to end happily however you slice it,” she said.

The warning came as Spain’s authorities were forced to shoot down German media reports that Madrid was preparing to tap the rescue facility after ructions in the inter-bank market.

Carlos Ocampa, Spain’s treasury secretary, said smaller Spanish banks are struggling to roll over debts but denied that the country is seeking outside help. “The rumour is false,” he said.

Spanish banks increased reliance on funds from the European Central Bank to a record €86bn in May.

Greece’s woes increased further as Moody’s downgraded Greek debt to junk status, saying the “macroeconomic and implementation risks associated with the programme are substantial”. The move is largely symbolic at this point since the European Central Bank has suspended its rating requirements for use of Greek debt as collateral for loans.

Greece is almost entirely shut out of the capital markets. Private investors are believed to have offloaded €25bn of Greek debt on to the ECB as it steps in to shore up the market, shifting the credit risk on to tax payers.

Axa said there was “no chance” that the EU’s €750bn “shock and awe” shield will succeed since it treats Club Med’s debt trap as a short-term liquidity crisis.

In the case of Greece the joint IMF-EU policy will increase Greek public debt from 120pc to 150pc of GDP by 2014, arguably making matters worse.

A number of ex-IMF officials have said the policy is doomed to failure since there is no devaluation or debt relief to offset the ferocious fiscal squeeze, and may endanger the credibility of the Fund itself. The IMF had floated the idea of a debt restructuring but this was blocked by the Brussels.

The strategy assumes that voters in Greece and other Club Med democracies will endure years of pain for the sake of foreign creditors. “It’s a pipedream,” said Ms Zemek.

Contagion from a Greek default would be harder to control than fallout from the Lehman collapse. “This has huge implications for banks. These bonds didn’t just disappear; they went somewhere, allegedly into French money markets and insurance companies, or on to French balance sheets,” she said.

The Bank for International Settlements said French and German lenders have £650bn in exposure to Greece, Ireland, Portugal and Spain, mostly in mortgage and company debt rather than sovereign debt.

The distinction has become meaningless in Greece. The ECB has lent Greek banks €85bn, mostly in exchange for collateral in the form of Greek government bonds.

This has kept Greek lenders alive as they suffer a slow bank run, losing 7pc of their deposit base since last June as wealthy Greeks shift their funds abroad. The ECB support is equal to 20pc of their non-equity funding, according to Lombard Street Research.

Axa said the America’s currency union is successful because Washington has over-riding legal powers over the 50 states.

“It is a precondition for the system to work but it doesn’t exist in Europe and the bond markets are starting to figure this out. We are looking at a noble experiment on the brink of failure,” said Ms Zemek.

Investors are placing bets on a Black Monday size crash in the British stock market at the fastest rate since the collapse of Lehman Brothers bank in 2008, the Bank of England has warned.
In a survey of markets, the Bank warned that widespread fear over the possible collapse of a sovereign debtor, including Greece and Portugal, had sparked a mass of bets on a 20 per cent fall in the FTSE 100.

The warning coincides with calculations from the Bank for International Settlements (BIS) showing that Britain has major exposure to the Irish and Spanish banking systems, which many fear could be at risk in the next round of the financial crisis.

The Bank of England used its Quarterly Bulletin to warn that markets were under increased strain following the International Monetary Fund and European Commission’s bail-out of Greece.

It said that investors had fled into safe haven assets, including Treasury bonds, gold and, to some surprise, UK government bonds.

However, it pointed out that the number of investors betting on a 20 per cent fall in the FTSE 100 index, based on their purchase of options connected to such a scenario, had risen from below 5 per cent to about 13 per cent in the past month alone.

Although this is below the 25 per cent level around the time of the Lehman implosion, the rate of increase is similar.

Some analysts fear problems surrounding government bonds could trigger a repeat of Lehman-style events.

The BIS used its own Quarterly Report to point out that, although the strain had worsened throughout the international banking system, banks’ balance sheets were slightly healthier than in the early stages of the subprime mortgage crisis that led to the Lehman collapse.

However, it also pointed out that various countries in the euro area were particularly exposed to each other – both in terms of sovereign and private debt.

Banks headquartered in Britain had larger claims on Ireland £158 billion than banks based in any other country. Britain has a £103 billion exposure to Spain.

The leaders of France and Germany have urged the European Commission to impose an EU wide ban on speculative trading known as naked short selling on euro financial instruments.It is a show of unity meant to ease concerns about policy divisions between the two biggest eurozone countries.

Germany’s Chancellor Angela Merkel and France’s President Nicolas Sarkozy urged the Commission president to speed up financial regulation.

The eurozone crisis will be the focus of an EU summit on 17 June.

Their joint letter follows the surprise postponement of a Merkel-Sarkozy meeting on Monday, when they were expected to co-ordinate their position ahead of the summit.

Short sellers usually borrow shares, sell them, then buy them back when the stock falls.  Naked short selling is when a trader sells financial instruments which they have not yet borrowed.

Berlin and Paris are calling on the European Commission to speed up work on stricter financial regulation, including proposals for an EU-wide ban of naked short-selling by July.

Last month, Germany surprised its EU partners by imposing a unilateral ban on the risky financial bets, blaming speculators for worsening the Greek debt crisis.

Germany is resisting French calls for an EU economic government with a new secretariat, meant to enforce closer co-ordination of the 16 eurozone countries.

The latest European administration to worry the markets is the new Fidesz Hungarian government, who suggested their predecessors had mis-led the population and markets about the financial state of the country.In order to try and prepare the population for the strict austerity measures that they will need to introduce, a newly appointed senior member of the government stated that Hungary has only “a slim chance” to avoid a “Greek situation”.

So with markets still concerned how the untried Fidesz Party are intending to marry up their populist policies with the austerity demanded by the IMF in return for its ongoing aid programme, the government’s first action was an apparent threat of default.

Given the Eurozone countries’ exposure to Hungary, it is no wonder that the Euro dropped in value. Concerted fire-fighting has limited further erosion this morning but EUR/USD has hit a new low of 1.1873 over night.

Over to the US and it was a disappointing Jobs report on Friday afternoon after figures suggested that 431,000 jobs were added to the economy in the month of May after it was widely considered to be in excess of 500k.

In addition to the top line weak data, the fact that temporary census workers accounted for 411,000 of the jobs could suggest that Uncle Sam’s recovery could be slowing.

Finally, David Cameron has spoken this morning and given a stark warning about the action needed to tackle Britain’s budget deficit and public debt. His key take outs were:

• Overall scale of deficit problem is even worse than we thought

• Potential consequences of deficit more critical than we feared

• Last government’s estimates show debt interest payments at 70 bln in 5 years

• Economic growth will not fix borrowing as much of deficit is structural

The euro will have broken up before the end of this Parliamentary term, according to the bulk of economists taking part in a wide-ranging economic survey for The Sunday Telegraph.
The euro is facing its worst crisis since it was founded with the survey’s findings underline suspicions that the new Chancellor, George Osborne, will have to firefight a full blown crisis in Britain’s biggest trading partner in his first years in office.

The single currency is in its death throes and may not survive in its current membership for a week, let alone the next five years, according to a selection of responses to the survey – the first major wide-ranging litmus test of economic opinion in the City since the election.

The findings underline suspicions that the new Chancellor, George Osborne, will have to firefight a full-blown crisis in Britain’s biggest trading partner in his first years in office.

Of the 25 leading City economists who took part in the Telegraph survey, 12 predicted that the euro would not survive in its current form this Parliamentary term, compared with eight who suspected it would. Five declared themselves undecided. The finding is only one of a number of remarkable conclusions, including that:
• The economy will grow by well over a percentage point less next year than the Budget predicted in March.
• The Government will borrow almost £10bn less next year than the Treasury previously forecast, despite this weaker growth.
• Just as many economists think the Bank of England will not raise rates until 2012 or later as think it will lift borrowing costs this year.

But the conclusion on the euro is perhaps the most remarkable finding. A year ago or less, few within the City would have confidently predicted the currency’s demise.

But the travails of Greece, Spain and Portugal in recent weeks, plus German Chancellor Angela Merkel’s acknowledgement that the currency is facing an “existential crisis”, have radically shifted opinion.

Four of the economists said that despite the wider suspicion that Greece or some of the weaker economies may be forced out of the currency, the most likely country to leave would be Germany.

The recent worries about the euro’s fate followed the creation last month of a £691 billion bail out fund to prevent future collapses. Although the fund boosted confidence initially, investors abandoned the euro after politicians showed reluctance to support it wholeheartedly.

After the money markets closed on Friday, Spain’s debt rating was downgraded by the ratings agency Fitch from AAA to AA plus with outlook stable.

The move seemed to have been priced into the market with very little movement in the price of the Euro over the extended weekend, but as the European trading session got underway on Tuesday, the Euro has come under renewed pressured and is now trading below 1.22.

On EUR/USD and over 1.18 against Sterling. The Spanish PM is facing mounting pressure to push through long awaited labour reform laws, with unemployment running at over 20% and huge amounts of pressure being applied by Spanish labour unions, we are entering a critical phase for Spain.

The recent ECB stability report has forecast further write-downs for European banks.

Sovereign debt contagion will spark a second wave of loan losses of greater magnitude than the £200 billion already written off up to December 2009 according to the report.

The ECB has also continued in its purchase of government debt, Portuguese, Spanish and Greek bonds have all been soaked up in the continuing effort to alleviate some of the fiscal strains affecting them.

David Laws, newly appointed Chief Secretary to the Treasury, resigned over the weekend over fresh MP expenses irregularities. Mr Laws has been replaced by Danny Alexander, a key member of Mr. Clegg’s negotiating team.

The news has caused concern in the markets because of the timing of the announcement and the nature of Mr Laws role in implementing the Governments policy of reducing the Budget deficit, temporarily at least putting downward pressure on Sterling.

The Reserve Bank of Australia kept interest rates on hold, a decision widely expected and already priced into the market. But the Aussie is coming under further pressure since the big move a couple of weeks back.

As continuing fears over the 40% super levy on mining companies gather momentum, it is still unclear if the large miners, widely expected to gain at least some concession in the deal, will get anything at and will have to bite the bullet and pay up.

Data revealing China’s housing market continues to overheat has also increased the downside pressure on the Aussie, since China is the main buyer of the raw materials that Australia produces.

With Italy following Spain, Portugal and Greece with a statement on its austerity measures, the Eurozone PIGS finally understand the severity of their problem.Unfortunately, it could be too late for Greece with reports in the FT claiming that “public debt to gross domestic product forecast to hit 150%”, which makes it hard to believe the country will correct its problems before the aid runs out.

Sterling continues to trade above 1.17 versus the Euro, after hitting an eleven month high yesterday. The UK currency was buoyed by talk of a failing take-over bid by Prudential for AIG’s Asian business, with the speculation also lifting sterling versus the dollar.

However, further momentum for sterling is limited after news that UK consumer confidence fell for the third consecutive month in May, reflecting uncertainty ahead of the election result and the prospect of fiscal tightening once a new government was in power.

According to figures released yesterday afternoon, the US economy grew in the first quarter at a slower pace than previously calculated, reflecting smaller gains in consumer and business spending and highlighting the risks to the recovery posed by the European debt crisis.

The 3 percent increase in the annual rate of GDP was less than forecast and compares with the advanced estimate of 3.2 percent issued last month.

The Australian dollar headed for its first five day advance in more than a month as Asian equities extended a global rally, boosting demand for higher yielding assets.

After previously dropping 7.4 percent so far in May, the Australian Dollar surged this week after China’s foreign exchange regulator affirmed its commitment to investing in Europe, triggering rallies in stocks and commodities.