The Great Debate UK

False dawn or risk recovery?

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

What began at the start of the year with an acknowledgement from Greece that it had been living way beyond its means soon turned into a more universal re-appraisal of the risks of sovereign default.

After Greece, the bond markets of Spain and Portugal were next to be re-examined.  More recently even the yields spreads of French and Dutch bonds vs German Bunds widened. Investors have shown themselves less inclined to finance the debt of countries which are not prepared to exercise budgetary prudence and governments have been forced to sit up and listen.

The rhetoric of this month’s G-20 meeting made clear that expansionary fiscal policies are off the agenda and that fiscal consolidation has become the new watchword of the majority of G-20 governments. Fiscal austerity clearly has an impact on growth potential and consequently on the market’s attitude towards risky assets.

The program of fiscal consolidation in the UK has just been launched.

Now safely in office the new coalition has been quick to let voters know the awful truth that deep public sector spending cuts are inevitable and will be “felt for decades”.

The UK’s budget deficit/GDP ratio may the worst in the G7, but it is by no means the only sizable industrialised country that has budgetary woes.  Market forecasts suggest the U.S. deficit could be 9 percent of GDP this year, but at least it is likely to perform better in terms of growth.

A hung parliament offers sterling little comfort

-Mark Bolsom is head of the UK Trading Desk at Travelex, the world’s largest non-bank FX payments specialist. The opinions expressed are his own.-

The final results are almost fully in and despite months of intense speculation the hung parliament outcome has come as an almighty shock to the financial markets.

As the likelihood of a decisive majority began to ebb away early this morning, sterling fell to a 12 month low against the dollar ($1.4476). And despite the euro’s weakness, sterling plummeted 3 percent in the middle of the night against the single currency, an unprecedented drop at that point during the day.

A hung parliament verdict was always going to be the markets worst nightmare and it really is a spectacularly disappointing result. Rightly or wrongly, the financial markets believe a hung parliament will hamstring the government when they come together to create a workable plan for reducing the deficit.

It is difficult to assess whether this is a legitimate concern – certainly there is wide acceptance across the political spectrum that tackling the deficit is the main priority – so it would seem strange for the parties to delay any decision making.

However, whilst it is very unlikely a similar situation will occur in Britain, the crisis in Greece does show what can happen if the markets do not accept the debt-reduction plan.

If we are to avoid a similar reduction in credibility and a resulting downgrade in our credit rating, it is crucial the government cooperates in the early stages of next week.

The Greek story is not over yet

- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

By rushing extra austerity measures through parliament last week and finding very good support for its bond sale Greece last week pulled its way clear of the edge of the abyss.  This is not the end of the story, however, but rather just another chapter in the fledging system which is European Monetary Union.

The euro found support in the positive developments surrounding Greece at the end of last week, and on rumours that a key European institution was on the bid in EUR/USD.  But the Greek story is not over.  Not only does the country still have to prove that it can implement this year’s austerity measures but it will take years before it can build up a track record of budgetary prudence.

In the interim there will be risks that Greece’s problems will again rise to the fore and that strains on EMU will again emerge.   More significant than Greece itself it the fact that it has opened the market’s eyes to the inadequate fiscal controls of EMU.

Greece, Spain et al should not have been allowed to squander the opportunity for budget reform that the ‘fat’ years of growth presented to them.  In this respect their respective governments were as guilty of taking too much risk as were the bankers that fuelled the financial crisis.

If EMU is to prove it can be sustainable over the long term, than stricter adherence to fiscal controls is necessary.  In essence the development of a European Monetary Fund thus seems like a good idea.  Whether or not the legal framework of the EU can be negotiated to allow it to be set up is another matter entirely, but it is essential for the future of EMU that the process that has not been embarked upon by politicians aimed at strengthening fiscal controls does yield fruit of some sort. In recognising that budget reform will involve a variety of measures likely to cut real (and in some cases nominal) wages, pensions, welfare benefits and (for a temporary period) employment it becomes clear firstly that there will be difficulties in adhering to it; particularly given the additional constrain of a strong and inflexible currency.

It also becomes obvious that reform will coincide with years of slow growth.  This is likely to be felt most acutely in Southern Europe.  However, insofar as Spain is Germany’s eighth largest export partner the drag is likely to feed back through the Eurozone.

Greece loses a major incentive to stay within EMU

-Jane Foley is research director of Forex.com. The opinions expressed are her own.-

Germany’s Finance Ministry this week denied a report in Le Monde that Germany, France and other countries were working on a package to rescue Greece. It seems that for now the official line from the grandfathers of European Monetary Union is that Greece can sort out its own budget deficit. The official line from the Greek government is much the same; it continues to maintain that it doesn’t need a bailout.

The problem with this is that this lacks credibility. The blowing out of the yield spreads on Greek government bonds over bunds and the price of credit default swaps are evidence of that. In the months after EMU, the 5 year Greek-bund spread was less than 200 bps. This week it was over 400 bps. Unless the impact of bond yields can be contained Greece loses a major incentive to stay within EMU.

As with many of the less well fiscally managed countries in the approach EMU in 1999, Greece benefitted hugely from convergence trades. Technically, the spread between Greek bond yields and Germany’s should have closed only after budgetary reform led to a much smaller budget deficit.

In practice what happened with many countries is that the market pre-empted the convergence trade and the countries which had previously suffered from high debt maintenance costs saw the burden of financing their deficits decline markedly. In turn the savings made on financing the deficit hid the fact that true budgetary reform was in certain cases avoided. Years of strong growth allowed the government in Greece to get away with it. That the recession has uncovered the cracks is not really a surprise.

While EMU offers Greece many political advantages, the question now must be can it afford to stay within EMU? It is no longer benefitting from German-like bond yields and it is suffering the pressure of what is still a very strong exchange rate. It is not without precedent that a country can turn its fiscal situation around. Sweden’s experience in 1994 is a very good example of this. Canada also suffered years of austerity in the 1990s and transitioned its economy into one which was better positioned than most to cope with the latest recession.

Ireland also appears to be swallowing the bitter bill of budget reform. What makes Greece different is that it is highly questionable as to whether the electorate have the stamina to suffer reform. The farmers have this month been blockading roads; the risk of rising social discontent is high.

Too soon to predict that EMU will wobble

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The budget crisis facing the Greek government has drawn an array of comments and responses from various parts of the European Central Bank, the European Commission, the International Monetary Fund and the financial markets.

Academics and economists are also keen to get their pennies worth pointing out that in effect the Greek budget was an accident waiting to happen.  During the early years of the Economic and Monetary Union it was no secret that some members of the system “fudged” their numbers to comply with the budgetary criteria of the Maastricht Treaty.

Such countries should have used the good growth years to initiate structural reform and fiscal restraint which would have promoted a healthy budget.  In the event that they did not it would only take a recession to uncover the cracks that had been papered over.

The opponents of EMU now have their moment.  The recession arrived and countries such as Greece, Spain, Portugal and Ireland found themselves to be in deep water.

The Irish appear to be swallowing the bitter pill of austerity but remarks by the Greek PM last month that Greece was plagued by tax evasion have heightened scepticism over whether Greece can achieve its aim of cutting the budget deficit to 3 percent of GDP by 2012 (from 12.7 percent currently).

So great are the issues in Greece that talk is emerging that the country may have little practical option but to leave EMU.  From an economic point of view there is validity in these arguments.

Tides may turn in the forex market into 2010

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The final weeks of 2009 have brought a sense that tides may be turning in the foreign exchange market reflecting broader developments in the global economy. The predominant changes relate to the dollar.

December’s 5 percent recovery in the USD index is linked to an improved outlook for the U.S. economy.

There are risks to this optimism, but short dated U.S. yields have pushed higher since late November allowing the dollar to shrug off the downtrend that characterised it during 2009 and potentially embark upon a cyclical recovery; at least against some currencies.

Better U.S. economic data in early December couldn’t have come soon enough for the Japanese authorities. In late November USD/JPY had fallen to a 14-year low.

Having proclaimed the economy to be in deflation the Japanese government openly pressured the Bank of Japan to take further supportive policy measures.

The Bank announced an emergency credit facility and subsequently stated it will not tolerate a negative inflation rate. This, combined with a rise in short dated U.S. yields, has allowed the JPY to take back the mantle of favoured funding currency from the dollar. The downtrend in USD/JPY that has been in place since mid 2007 may be turning.

Development of the risk trade

- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

A willingness to differentiate between risk on a country or at a regional level is an important part of the repair process in financial markets.

Credit worthiness is at the core of any assessment of risk and naturally credit worthiness can sort “risk” into a hierarchy which should be instrumental to the pricing of assets and currencies.

At the start of this year, fear and uncertainly herded investors in and out of “risky” investments fairly indiscriminately. Even though the overall rally in risk since the spring suggests that broad based fear has been dispersing, strong correlations between some of these “risky” assets persist.

Forecasts of slow levels of growth for most of the G10 in 2010 suggests that there are still a few more negative shocks in store for the markets in the coming months.

That said, reduced levels of fear should allow fundamentals including assessments of credit worthiness to play a greater part in asset allocations.

Will inflation soar when QE is withdrawn?

- Mark Bolsom is Head of the UK Trading desk at Travelex, the world’s largest non-bank foreign exchange and international payments provider. The opinions expressed are his own. -

The rise in November’s CPI figure was larger than expected, but not a total surprise and markets have largely ignored the data.

In the Bank of England’s quarterly inflation report, published last month, Mervyn King reiterated his belief that short-term inflation looked set to rise quite sharply, in line with higher oil and petrol prices. There is little doubt as well that Sterling’s relative decline against a basket of other currencies has also contributed to inflationary pressure. This is particularly significant for the UK, as Britain remains a net importer of goods, and thus far there has been no sign of a reduction in the trade deficit. In fact the trade deficit actually widened to 3.2 billion pounds  in October from 3.1 billion pounds in September 2009.

In the short-term, we expect inflation to carry on rising, as the reversal in VAT, scheduled for January (currently at 15 percent, set to revert back to 17.5 percent), will add to inflationary pressures. As the pace of the global recovery picks up, we also expect the cost of raw materials to increase, further adding to upwards price pressure and quite possibly pushing inflation to 3 percent by the end of the first quarter in 2010.

Nevertheless, even with the pick up in underlying inflation, the higher CPI number is unlikely to significantly impact the Bank of England’s monetary policy. Mervyn King has stated that he will be focussing on the medium term outlook, preferring to concentrate on spending relative to the spare capacity in the UK economy. Given this outlook, and the probability that wage inflation is also likely to remain subdued, we expect the Central Bank to persist with a policy of low interest rates. We expect rates to stay on hold at 0.5 percent until 2011.

However, only when the MPC start to withdraw their quantitative easing programme will we get a true indication of the currently bolstered CPI figure. Thus, the real question is what will happen to inflation rates when the MPC start to withdraw economic stimulus?

Gold rally could start to tire

Spot gold prices are up over 40 percent year on year.  Yet, according to the World Gold Council, demand for gold in the third quarter of 2009, dropped by 34 percent year on year.  Of course, demand in the third quarter of 2008 was exceptionally high due to the financial crisis. As well, relative to the third quarter average of the five years to 2007, demand for gold in Q3 2009 was down 4 percent.

When confronted with the ferocity of the rally in gold, the fact that the third quarter demand for gold was below the seasonal average is surprising. The dynamic between price and demand suggests some fall in supply perhaps led by increased hoarding.

According to the council mining supply is fairly inelastic.

Supply of recycled gold generally helps stabilise the price, in recent years this has been 28 percent of annual supply.   Between 2003 and 2008 central bank sales represented the third biggest source of supply.

It remains unclear what the recent gold purchases from the Central Bank of India means for the demand/supply dynamic of gold going forward.

What is clear, is that the gold rally has been exacerbated by dollar weakness, but this only offers a partial explanation.  The dollar index is at 15-month lows.  In August 2008, gold traded at an average rate of $836.84.  Other factors that have chased gold prices higher include the lack of return on cash and fear of inflation.   The former will almost certainly support gold in the coming months, but the inflation argument has no legs.

Following a year packed with fiscal spending and the introduction of Quantitative Easing, Fed chief Bernanke recently said “inflation seems likely to remain subdued for some time”.  If high unemployment and rising savings rates are insufficient evidence of subdued price pressures, lessened availability of credit at a consumer level should drive home the point.

Risk trade yet to show signs of fatigue

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

A month or so ago, there was a lot of talk that risk appetite would be pared back over the coming months. This talk was built around relatively cautious expectations for economic growth in most of the G-10 next year.

These cautious projections still stand. However, it is interesting that the risk trade suffered only a brief decline following the shock rise in the U.S. unemployment rate to 10.2 percent and the surprisingly strong fall in the University of Michigan confidence index.

Comments this week from Fed Chairman Ben Bernanke warning about “headwinds” that still face the U.S. economy have led to some paring back of risk but with poor economic data unable to cause a reversal of the uptrend in equities it seems that the risk trade is yet to exhibit many signs of tiredness.

The ability of markets to cast aside weak U.S. economic data centres on the outlook for Fed rates. Weak data is feeding the notion that Fed rates will stay lower for longer and this, it seems, is feeding appetite for risk.

The ability of the risk trade to remain undeterred by weak U.S. data feeds the accusation that the Fed is facilitating the risk trade and the dollar remains a preferred funding currency.

While the USD may be acting as the preferred funding currency, low interest rates are affecting investment decisions everywhere. Latest data from the UK’s Investment Management Association (IMA) confirm a bias away from cash into higher yielding assets.