However, the firm emphasised that the downgrades did not “reflect a deterioration in the financial strength of the banking system”.

Moody’s also downgraded nine Portuguese banks, blaming financial weakness.

Shares in both RBS and Lloyds were among the FTSE 100′s biggest fallers, down 3.7% and 2.7% respectively in afternoon trading.

Seven UK building societies were among the firms downgraded, a move that the Building Societies Association (BSA) called a “normalisation” that had “been expected for some time”.

“It does not represent any change in financial strength and it is business as usual across the sector,” the BSA said.

Analysts and investors watch closely the ratings that firms such as Moody’s put on the creditworthiness of companies and governments.

Along with Standard & Poor’s and Fitch, Moody’s is one of the big three agencies. Their ratings influence heavily the amount interest that companies and governments pay to borrow money.

“The downgrades have been caused by Moody’s reassessment of the support environment in the UK which has resulted in the removal of systemic support for seven smaller institutions and the reduction of systemic support… for five larger, more systemically important financial institutions.”

The downgrades include a two-notch cut for government-controlled RBS, to A2 from Aa3, and a cut of one-notch, to A1 from Aa3, for Lloyds TSB, a division of part-nationalised Lloyds Banking Group.

Spanish bank Santander had its UK business downgraded by one notch, to A1 from Aa3, while Nationwide Building Society suffered a two-notch cut, to A2 from Aa3.

Other institutions downgraded were Co-operative Bank, and the building societies Newcastle, Norwich & Peterborough, Nottingham, Principality, Skipton, West Bromwich and Yorkshire.

The rating cuts did not concern HSBC, Barclays or Standard Chartered, Moody’s said.

RBS said it was “disappointed” that Moody’s announcement did not reflect the “significant progress” the bank had made to restructure it finances.

Lloyds said that it believed Moody’s was reflecting what was already understood in the market, and that it would “have minimal impact on our funding costs”.

Nationwide said that Moody’s announcement was part of an industry-wide review, and “not a reflection of Nationwide’s business model”.

The Chancellor, George Osborne, said one reason for the downgrades was that the government was seen to be “trying to deal with the too-big-to-fail problem”.

Mr Osborne said he was confident that British banks were well-capitalised. “They are not experiencing the kinds of problems that some of the banks in the eurozone are experiencing at the moment.”

Moody’s split the downgrades into three categories.

Banks with a “high likelihood of support” are RBS and Lloyds.

Banks or building societies with a “moderate or high likelihood of support” are Nationwide, Santander UK, Co-operative Bank, and Clydesdale Bank. Clydesdale’s rating was reaffirmed, not cut.

George Osborne: “They think the British government is actually moving in the direction of trying to get away from guaranteeing all the largest banks in Britain”

Under the spot light this week are retail sales, inflation, industrial production and regional manufacturing surveys which will offer some direction to the Greenback and it is likely that the data over coming days will look less negative than in past weeks, giving the US Dollar some support. 

On the other hand, EUR/USD continues to struggle, falling below its 200 day moving average in spite of positive news from Germany (rejection of bills in the constitutional court) and China assisting the Italians with their bond programme yesterday.

The ECB did not help the EUR’s cause however, with the change in its stance to a more balanced assessment of risks from its more hawkish stance previously.

However, the real damage occurred as speculation of a Greek default intensified and ECB hawk Stark resigned from the ECB council, highlighting the divisions within the governing board.

This week attention will remain on Greece as negotiations between the Troika (ECB, EU and IMF) and Greek officials resume.

Ahead of the talks Greece approved a further EUR 2 billion in austerity measures over the weekend but nonetheless, despite denials by Greek officials speculation of a debt default will continue to hammer the EUR lower.

So far today we had CPI data which came in at 4.5% from 4.4% in July according to figures from the ONS.

This sits well above the Bank of England’s target rate of 2% which is expected to return back to target within two years.

The ONS blamed continued pressure in energy prices as well as clothing& footwear but accepted some relief in transport services and recreation in particular game consoles helped to offset further price rises.

Sterling took a hit yesterday against most of its major rivals as investors look towards tomorrow’s GDP number from the UK.

The Pound has been buoyant recently and trading near 5 months highs though if the data does come out lower than the estimate, we could be set for a new downward trend for Sterling.

The US has had raft of data out recently with yesterday’s durable goods numbers coming in better than expected. They showed a 4% MoM increase in the number of new orders in the US which is a massive boost to the struggling economy.

The main focus for this week is tomorrow’s release of the US GDP followed by FED chief Ben Bernanke’s speech.

The expectation is for 1.1% growth in the most recent quarter from the GDP figure which would be yet more positive data for the States.

As we posted yesterday, Bernanke’s speech, coming from Jackson Hole Wyoming, he will be delivering key points for the US recovery which will lead onto the rest of the World.

The markets are looking for the Chairman to signal fresh steps to prop up the US economy with potentially more Quantitative Easing measures.

The euro vs US Dollar contest continues its rollercoaster ride this morning.

Fears over sovereign debt and bank solvency concerns are spreading inwards from the periphery into the ‘core’ Euro-zone economies like a swarm of locusts, once the feeding frenzy in one country subsides, the market moves on in search on the next weakest link.

The US Dollar is a good barometer for fear, and a four cent move in two days should indicate just how uncertain the Euro-zone situation remains.

That said, the size of the move is probably now overdone, so we can expect a modest retrace back over the 1.39 level as the market awaits an update on the resolution to further bail-out deals.

The net result of the volatility in the Euro-Dollar pair has been to pull Sterling in both directions.

Down against the Dollar and up against the Euro.

Both moves reflect only the large movement in the EURUSD and not anything Sterling specific.

UK CPI inflation for this month has just been released, the market had been expecting further increases and the yearly figure to push toward 5%, but the monthly figure showed a welcome decline of 0.1% and the first decline in June since 2003.

The Bank Of England are probably slightly relieved since they have persistently been calling the above target inflation temporary, but before we get excited the size of the decline is so small that it could be revised upwards, and so to positive territory very easily.

The market is clearly in a situation of buying the rumour and a sell of the fact could be on the cards – the yes vote is not a foregone conclusion as the socialist ruling party only have a tiny majority of six in 300 seat parliament.

It is squeaky bum time for Greece and the Euro- for now.

Even in the light of today’s critical vote it is the Pound and not the euro which looks as though it has been through 12 rounds.

The beleaguered Pound has fallen 8.9% in the last year and covets the accolade of second worst performing currency among 10 developed market currencies behind the US Dollar according to Bloomberg.

So why is the pound so weak?

Well in a nutshell we have recently seen GDP dip further against forecasts, mortgage approvals are set to remain near a 4 month low in May (data due at 9:30) and interest rates are set to remain low.

However the nail in the coffin is the retail sector which is struggling and consumer confidence is waning fast- the Asda CFO summed it up well today in the Telegraph stating that British consumers are starting to ration as fear and uncertainty grips consumers.

This certainly challenges the government’s austerity plans- if this mood prevails, plan A will certainly fail as growth will be hamstrung by a lack of consumer appetite and with no plan B the UK could be in for a rough ride.

Sterling remains vulnerable to an upturn in risk appetite especially given the diminishing likelihood of a UK rate rise at the May MPC meeting following yesterday’s inflation figures.

This trend will encourage the view persistently expressed by Mervyn King and most of his BoE colleagues on the committee, that the recent spike in inflation was just that.

He has argued for several meetings that the MPC putting rates up as a counter to a sharp rise in imported inflation, when the spike is expected to correct itself quite quickly, is a pointless exercise.

This opinion looks more likely to be borne out following yesterday’s data, but could easily prove to be a 2-edged sword for Sterling.

The reduced prospect of interest rate rises in the UK combined with higher yields elsewhere leaves the Pound extremely susceptible to further declines against the Euro and commodity focused currencies.

The much reduced UK trade deficit was a bright spot, but the implication derived from the numbers is that the pick up in exports was as a result of the weaker Pound; a scenario that has been touted by both the BoE and the Chancellor, which again suggests little enthusiasm for any recovery in Sterling for the time being.

Yesterday, it was the turn of a Fed hawk, the Dallas President Richard Fisher, to air his views on current policy.

In an article published by a German newspaper this morning, he was quoted as saying that the Fed risks having maintained a monetary policy that is too expansive adding that, ‘It can now hardly be disputed that US businesses have enough financial fuel in the tank to grow and create jobs’.

He said that the Central Bank did what was needed when financial panic broke out back in 2008, but that the situation was much different.

Debate at upcoming FOMC meetings will become more intense with both doves and hawks seeking to sway Bernanke’s thinking their way.

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%.

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.

Dominique Strauss-Kahn the IMF’s Managing Director said co-operation between countries had weakened since the financial crisis started in 2008.

There is also the risk of bubbles in financial and property markets. And capital inflows can go into reverse – as they did in the Asian crisis in the 1990s.

So the third element in the currency “war” is the resistance of emerging economies, and some developed ones too.

Brazil and Thailand have used tax measures to slow the inflows. Japan, South Korea and others have intervened in the currency markets, buying foreign currency in an attempt to interrupt the rise of their own.

There is a view that they will just have to live with it. The upward pressure on the currencies of many emerging economies reflects the fact they are more growing strongly than the US.

It is difficult for them to manage, but the underlying reason is that they are doing relatively well.

The currency war is closely linked with another theme that has been troubling many economists for several years, that of global economic imbalances.

In international terms, it is trade that is unbalanced. Actually, the thing that is most often the focus is the “current account balance”, which means trade in goods and services plus some financial items, including remittances that migrant workers send home.

Usually, though, trade is responsible for most of the current account imbalance.

Some countries have large trade surpluses, notably China, Germany, Saudi Arabia and Russia. The biggest deficit country is the United States.

Some countries at the eye of the European storm have hefty deficits too – the PIGS aka Portugal, Ireland, Greece and Spain.

Britain also has a deficit, although as a share of national income, it is not all that large.

The other side of international imbalances is high savings at home with a surplus country such as China, and relatively low savings in a deficit country such as the US.

Household savings have risen in the US, the UK and other deficit countries, because consumers are borrowing less in the wake of the financial crisis.

But international imbalances also reflect how much governments borrow and in many deficit countries that has risen, partly offsetting the increase in private savings.

Why does all this matter? Those countries where saving has risen desperately want to export more. They want to sell more abroad to make up for consumers at home drawing cutting back their consumption.

That is true of the US, Britain and many others. They could do that more easily if consumers in China and the other surplus countries were willing to buy more imported goods.

A rise in China’s currency would not be a cure all, but it would probably help in the short term. Although it would also create greater inflation.

For his part, Brazil’s Guido Mantega said competitive devaluations by advanced countries amounted to a new trade war.

“We’re in the midst of an international currency war,” he told a meeting of industrial leaders in September. “This threatens us because it takes away our competitiveness.”

There are three key elements, two of them fairly new, but the first is a long standing one.

It is China’s policy of managing its currency and limiting its movement against the US dollar.

It has been though several phases and during the financial crisis, China went back to keeping the yuan from rising.
Clerk counting 100-yuan notes China is trying to hold the yuan’s value down

Since just before the Toronto G20 summit in June, it has eased the controls and allowed the currency to move up against the dollar, but by less than 2.5% (as of now). And because the dollar has fallen, the yuan has dropped against many other currencies as well.

The reason for the Chinese reluctance to allow the yuan to rise much is a fear of job losses among export industries that would be made less competitive.

The rise against the dollar has not been enough to satisfy the US, where there is a long standing complaint that China manipulates its currency to gain an unfair advantage. The cry is: “It costs American jobs.”

Many in the US complain about China, but they are not innocent either.

The dollar has fallen sharply in recent months, because interest rates are low, so investors have been seeking higher returns in emerging economies.

They need to buy the currency of the country concerned to make those investments. That tends to push its value up, while the dollar, which they are selling, tends to fall.

And the effect is aggravated by the Federal Reserve’s other policy, known as quantitative easing. The Fed buys financial assets and the money it pays with has to be invested somewhere.

The weak dollar has an advantage for the US – it’s that competitiveness issue again. It should help American exporters.

The US has a large trade deficit, so more exports could help fix that. Many argue that the Fed’s policies are actually intended to weaken the dollar and help the US economy recover by exporting more.

The Fed’s policies have led to a wave of money-seeking opportunities in the emerging economies. That tends to push their currencies up, undermining their competitiveness.

There is also the risk of bubbles in financial and property markets. And capital inflows can go into reverse – as they did in the Asian crisis in the 1990s.

This kind of addition would equal a 25% increase in the holding of gilts by the BoE – a sizeable sum.

Naturally, the vote for no change outweighed Posen’s submission and also Andrew Sentence’s regular demand for a withdrawal of liquidity on perceived inflationary pressures.

Sterling didn’t react too well to the outcome – nothing serious but just looked a little vulnerable.

The Budget cut provided little additional information – lots of numbers and political jargon but nothing unexpected for the money markets to react to.

The more prevalent remarks came from the Institute of Fiscal Studies within a report released overnight.

In it they questioned whether the Government’s UK growth projections were overly optimistic and that there was a possibility that the £ 80 billion – odd of cuts might not prove to be enough.

Sterling reacted badly to this forecast, and fell to a 6-month low against the Euro.

Overseas investors are going to need verification that the behaviour taken would produce results before they get their assurance in the currency back. This will leave Sterling prone to continued downside pressure in the short term.

For global currencies, and ahead of this weekend’s G20 meeting in South Korea, two events have provide this morning’s interest. An interview with the US Treasury Secretary, Tim Geithner, reported in today’s Wall St Journal proved interesting reading.

He emphasised that the US had not embarked upon a policy of devaluing the US Dollar and that the strong dollar was still vital for global stability and recovery and that the major currencies values were roughly in line.

He did however divide countries into 3 groups and pointedly entitled the first, which included China, as those whose currencies were “undervalued by any measure”.

He berated the emerging market countries for not allowing market forces to set currency values (especially China) and stated that they all had a role to play.

He added that, “If China knew that if it moved more rapidly, other emerging markets would move with them, it would be easier for them to move.” This could all make G20 a bit lively with the US seemingly trying to create a them and us situation with the us being the ‘good guys’ and the them being cast as the villains.