WISE MONEY

After markets closed last night, Standard and Poor’s (S&P)  the credit rating agency dealt a severe blow to the European bailout fund by downgrading its AAA status to AA+. The agency blamed the large number of guarantors that had lost their triple A crown and therefore the funds itself could not maintain the gold standard rating.

Following the announcement, EU officials attempted to reassure markets that the funds will not change is ambitions to lend billions of Euros to struggling Eurozone states.

Proving how out of touch euro technocrats are the EFSF chief Klaus Regling claimed “The downgrade to AA+ by only one credit agency will not reduce EFSF’s lending capacity of €440 billion”.

This latest downgrade will increase pressure on Eurozone officials and German government to boost their contribution to the European Stability Mechanism which only becomes active in July.

Interestingly the euro has rallied so far following the announcement and currently sits at 1.2021 against Sterling and up against the Greenback at 1.2790.

This morning in the UK we had the latest CPI reading which indicated a 4.2% year on year according to the Office for National Statistics.

This is further fall following last months 4.8% figure and eases inflationary pressure on the Bank of England as it creeps lower towards the 2% target level.

This is the biggest year on year decline since April 2009, which was attributed to discounts on petrol gas and clothing according to the ONS.

The US re-opens today following its Bank Holiday for Martin Luther King day yesterday.

They start their week with Empire manufacturing data which assesses business conditions and expectations of manufacturing executives specifically in New York.

This is followed by a Canadian Interest rate decision where we are expecting them to maintain interest rates at 1.0%.

Fairly dovish comments by Bank of England officials and weak data will keep the Pound on the back foot over the short term. BoE governor King highlighted the risk of an inflation undershoot while Fisher noted that the BoE expanded QE by a minimum in October and can do more.

Yesterday’s Autumn statement was a mixed bag for the markets.

George Osborne announced two more years of austerity measures following official figures indicating that the national debt was spiralling out of control due to rising unemployment and flagging economic growth.

Fitch reacted by suggesting that the UK was now the most indebted AAA country in the world with the exception of Uncle Sam who lost their full status earlier this year.

The Greenback was dealt a blow by Fitch, the rating agency, as they changed their outlook on the US AAA long term rating to negative.

Nevertheless, Dollar reaction has been strong, with long positioning moving to multi week highs.

The Dollar could face a struggle from the rumour that the Fed is about to embark on a fresh round of QE by buying mortgage backed securities.

The strong start to the week in terms of risk appetite aided a brief Euro rally but the currency remains susceptible to event risk.

High among them the Eurogroup and Ecofin meetings this week, which will decide whether or not to approve Greece’s next loan tranche as well as EFSF leveraging options.

Development is expected to be restricted leaving the euro defenceless to a fall.

Under the spotlight today will be Italy’s sale of up to EUR 8 billion of Italian Bonds and the likelihood that the country may have to face a yield above the critical 7% threshold.

An increase in funding costs will not bode well for EUR sentiment especially following warnings by Moody’s about potential downgrades to sovereign ratings across the region.

At the time of writing there are rumours of ECB again getting involved in bond purchasing.

EUR/USD failed to follow through on gains overnight but as reflected in the IMM; speculative positioning may have some scope for further short covering given that the net EUR short position reached its highest since June 2010 last week.

Nonetheless, upside potential for EUR/USD is likely to be restricted to resistance around 1.3415.

The UK’s monthly inflation report brought another set of disappointing expectations for Britain’s outlook over the next 3 years. Inflation is expected to fall rapidly in 2012 before dropping below the target rate of 2% in 2013 and 2014.

The report goes on to say the Bank predicts sluggish growth of around 1% for next year with the slump lingering into 2013.

Based on these forecasts and the Monetary Policy Committee’s dovish view, the forecast is for £50 billion more of quantitative easing in early 2012 and a further £25 billion towards the middle of the year.

This is on-top of the extra £75 billion extension to the asset buying programme.

BoE government Sir Mervyn King warned “We have been going through extraordinary times and in such circumstances, there are limits to what domestic monetary policy can achieve”. All in all, a pretty dim look going forward for the UK.

We also had the UK’s Retail Sales figure for the previous month released today showing a 0.6% increase MoM.

This had very little effect on Sterling as the markets are continuing to move on the bigger issue surrounding the European debt crisis.

The euro has remained weak on the back of this while the Greenback has continued to strengthen as investors look for a safer place for their money.

UK manufacturing sector growth fell to its lowest rate for 21 months in June as new orders declined.
The Markit/Cips manufacturing purchasing managers’ index (PMI) for June fell to 51.3, down from May’s downwardly revised measure of 52.0.

A figure above 50 indicates expansion.

Markit said that growth was “stalling”, with weak domestic demand and the recent boost to exports now fading.

However, there were signs that inflationary pressures had eased.

“The manufacturing sector continued to slip closer to stagnation in June,” said Rob Dobson, senior economist at Markit.

“The data will call into question the sector’s ability to play a major role in delivering a robust and sustainable economic recovery.”

The rate at which companies were hiring staff slowed, and new orders fell for the second month in a row, Markit found.

However, there was also a sharp fall in the inflation rate for goods that manufacturers buy.

“Input price and supply-chain pressures eased noticeably in June, which will… add weight to the Bank of England’s monetary belief that the current spike in inflationary pressures will prove transitory,” said Mr Dobson.

Most of the main European markets, including Germany, France, Switzerland and Spain are closed today, so expect light trading until the US opens around lunch time. First up, data from China this morning showed the supply of new loans in May well below market consensus.

Any missed numbers from China are bearish for risk assets, and we can expect the US Dollar to do well today on the back of this news.

For the rest of the week US data is light, CPI figures are due on Wednesday but with inflation pressures in the US much less of a problem than in the UK, the number is less closely watched by the market.

Friday sees the University of Michigan confidence survey for June released.

Going into the usually weak summer months, the market is looking for a bit of cheer given talk of the potential for a double dip.

The confidence figure is perceived as a leading indicator of economic recovery, and the market will jump all over a weak figure and the increased possibility of further QE.

UK data out this week include jobless claims on Wednesday and retails sales on Thursday.

Data on the health of the high street are very important to Sterling, given the role of the consumer in creating demand in the economy.

Recent numbers have been weak to say the least, and we can expect the trend to continue as retailers get squeezed by falling consumer demand and increasing costs as input prices continue to climb.

The key release, given that the media is currently cranking up the pressure on the Bank of England and their perceived failures, the CPI figure is particularly eagerly anticipated.

The surprises will remain to the upside for the foreseeable future and the Bank must be concerned that the market may begin to lose faith that they remain ahead of the curve.

The usual relationship between above target inflation and Sterling would be for the currency to rise in anticipation of the central bank raising interest rates.

This relationship may begin to invert if, by keeping rates on hold, the Bank starts eroding all of the economic brownie points it racked up in the past decade when inflation was low and stable.

The head of a leading economic body- the Organization for Economic Co-operation and Development (OECD) has insisted he does support the UK government’s deficit reduction strategy after his colleague appeared to suggest the pace of cuts might be too fast.
The OECD’s chief economist Pier Carlo Padoan had said earlier that the UK might have to change it’s plans if growth stayed weak. But secretary general Angel Gurria said that would only be needed if there was “a very dramatic drop” in growth.

Asked later whether Mr Padoan’s words signalled a watering down of the OECD’s support for the government, Mr Gurria said: “Oh no, I was there.

“He was being questioned about a hypothetical example about a very dramatic drop in the rate of growth, and whether one would then have to change course.  He said that if there are some terrible results or whatever we’ll have to take a look at it. But no way was there any signal of a change in course.”

Asked again if the OECD backed the coalition’s deficit reduction plans, Mr Gurria said: “Absolutely. We think it’s the way to go. We have said that you should stay the course and continue to support this route.”

The Treasury said the OECD had never swayed in its support for the government’s strategy.

Conservative MP Matthew Hancock said: “Ed Balls’ credibility has today sunk to a new low. His typically misleading attempt to claim the OECD’s support has spectacularly backfired.

“The OECD, the IMF and every major business organisation in the UK support the Government’s plan.”

Speaking on Wednesday, Prime Minister David Cameron said the government had been right to prioritise deficit-reduction since coming to office and cited the fact market interest rates had fallen in the UK – while rising elsewhere in the EU – as “proof” of international support for its deficit plans.

The Pound has shrugged off disappointing retail sales figures and a surprise drop in inflation earlier in the week and is trading up against the Dollar and Euro this morning. This is partly to do with the rise in British consumer confidence and positive employment data, but also is reflecting the fact that the market believes Tuesday’s CPI figure was merely a blip in the upward march of inflation.

The Bank of England has been working hard to keep our inflation expectations anchored recently, notice the increase in column inches of the MPC’s most hawkish member over the last few months.

But most of the subsequent reports by have been along the same lines: The fall in inflation is temporary and we expect prices to keep rising.

Does the market’s refusal to accept Tuesdays’ figure as a reversal in the inflationary trend mean the Bank of England is losing the battle of inflation expectations?

It means they are at least being questioned.

It also means the Bank needs to redouble its efforts in keeping wage and price growth expectations low and stable (unless you believe the conspiracy theory that the Bank is only aiming of nominal GDP growth).

Currently the US Dollar seems to be rallying as risk aversion dominates investor’s strategies following more aftershocks in Japan and spiralling nuclear fears, with Japan raising the level of the nuclear threat. However, any relief from pressure on the US Dollar is likely to be short-lived given the somewhat dovish Fed stance in comparison to other central banks.

The European Central Bank rate hike last week underlined its contrasting attitude with the Fed, providing further support for the euro.

Nevertheless, it’s worth noting that markets have already factored in two additional quarter basis point rate rises in the eurozone.

If this is the case, it would suggest limited upside potential for the EUR unless the ECB becomes even more hawkish, which seems unlikely.

Given the FX market’s interest on yield and interest rate differentials, this week’s inflation releases in the US, Europe and UK as well as various Fed speakers will provide market volatility.

The dollar also appears to have been helped by last week’s 11^th hour US budget agreement, which scarcely avoided a government shut down.

Any reprieve may prove to be temporary, given that there remains fundamental differences between Democrats and Republicans over medium to long term deficit reduction strategies.

Ultimately in the worst case scenario is the failure to increase the US debt ceiling if a deal is not reached by mid May.

Portugal remains in headlines after the country’s official request for a European Union bailout.

This week officials from the ECB, IMF and EU will be in the country to begin discussions on the terms and size of the aid package, with estimates ranging from EUR 80-90 billion.

FX markets have largely taken news of a Portugal bailout in its stride, but EUR/USD will continue to struggle close to the 1.45 level.

Sterling remains under pressure this morning as we await a large UK data release including 4Q GDP (final revision), current account and mortgage approval figures. It is difficult to tell whether it was anticipation of these figures or hawkish comments from various Federal Reserve governors at the end of last week that pushed Cable down from 12 month highs post budget, but the outlook for the UK economy has been significantly reassessed by the market and we may see the Pound test the key level of 1.5980, which has held in the pairs range trading over last few weeks, if today’s data disappoints.

Adding to the negative sentiment, business confidence fell to the lowest level in two years according to figures released yesterday and we also had comments from the Bank of England’s resident dove, Adam Posen, reiterating that he feels inflation will fall back below the 2% target as the government austerity measures and weak economy rein in what he sees as temporary inflationary pressures.

With several other members of the MPC due to speak this week and Andrew Sentance again calling for higher interest rates in an interview, the divergent views of the MPC are becoming more pronounced and a split MPC is most definitely Sterling negative.

It was another miserable day for Portuguese and Irish banks, the former being downgraded by S&P, the latter expected to need another slug of investment on top of the huge amounts already pledged to them by the Irish government.

And yet the Euro is almost unchanged against the Dollar and Pound and continues to reflect the prospect of a rate hike at next weeks ECB meeting.

The fact that Portugal will need a bail-out sooner rather than later is deemed irrelevant by the currency markets at these sorts of levels and begs the question of just what is needed to force a revaluation of the Euro. Germany running into problems would be one thing – but even a heavy defeat of Chancellor Angela Merkel in regional elections barely registered on the Euro barometer.

As with February’s Bank of England’s MPC meeting, the committee voted 6-3 in favour of keeping rates unchanged at the historic lows of 0.5%. The 3 is made up of Dale and Weale calling for a 25bps hike while Sentence continues to argue for a 50bps rise.

They also voted 8-1 to keep the quantitative easing programme at £200bn with Posen as usual wanting an additional £50bn added.

The main comments from the extensive minutes were for inflation likely to rise further with “significant risk” it will exceed 5% in the near-term.

This comes as little surprise following yesterdays higher than expected CPI and RPI figures showing producer prices rising 4.4% over the last year.

Other comments assert that recent events have increased uncertainty about the medium term outlook for growth.

Sterling has weakened on the back of these announcements as the growing uncertainty over whether the bank can increase interest rates to curb the surging inflation remains dominant and thus, brings the end of a positive start to the week for Sterling.

The most important event for the Forex markets over the coming trading sessions will be this afternoon’s Portuguese parliamentary austerity vote.

This could not have happened at a worse time for the Eurozone, in a week jammed full on meetings and summits to all intent and purpose to sign off an agreement for stabilising the region’s funding crisis.

A negative outcome at this afternoon’s vote could very well precipitate Portugal having to seek external financial assistance, and this is certainly the thought in the credit markets with the 10-year German/Portuguese bond spread widening sharply this morning.

If the Eurozone leaders, at tomorrows summit meeting fail to ‘tie up the remaining loose ends’ of the new financial rescue mechanism, then a reversal of the Euro’s fortunes could well be on the cards.