The Great Debate UK

Post stress tests: lending conditions likely to remain tough

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

The financial markets have been pre-occupied with all aspects of the EU bank stress tests over the past few weeks. For the man on the street, however, the debate boils down to just one question: when will credit become cheaper and more readily available?

The Bank of England recently reported that the stock of lending to business contracted by £2.3 billion in May.  Data from major UK lenders has indicated that net lending remained weak in June.

The lack of new credit is frequently blamed for stifling the pace of economic recovery.

Yet the banks cannot be held completely accountable for this.  One key legacy of the financial crisis was that bankers had to become more prudent when evaluating risk.

Not only that but banks currently face relatively high costs of raising longer-term funding.  This factor goes a long way to explaining why lending rates appear to be so much higher than the Bank of England interest rate.

The chart above  show the heightened price of a five year credit default swap on European banks (a CDS is an insurance policy in case the issuer were to default on its debt).  The surge in the price of the CDS this year reflects the view that bank debt has become a far more risky investment.

Double dip a done deal?

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

Earlier this week the S&P 500 was down 15 percent from its April 2010 high.   The ongoing debate on whether the U.S. economy is poised for a double dip recession can be linked with these falls.

At present there is insufficient evidence to conclude that the U.S. economy will fall back into recession, though there are signs that the recovery could be losing momentum.  A key question is whether the adjustment in asset prices seen since the end of April has been appropriate.

Proponents of double-dip imply that asset prices may have further to fall.  In contrast, die hard bulls suggest that equity valuations are looking cheap.  In the past few sessions, the bulls have been gaining the upper hand.

The reining in of government fiscal incentives and in many cases the implementation of austerity measures suggests that economic growth in most of the developed world will be constrained for the next few years.

The release a month ago of the much worse than expected May U.S. Labour report was followed by a bout of poor U.S. housing and confidence data  that had the effect of triggering a wide scale debate about the prospects for double dip recession in the U.S.

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.

Is the re-pricing in stocks and oil complete?

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

The better tone in stock indices and oil prices that has appeared this week begs the question as to whether the bout of re-pricing is complete.

The correction lower was arguably necessary to allow for the fact that the fiscal repair process which has started in parts of the Eurozone and will soon spread to the UK and then to the US next year will cap growth prospects for the industrialised world.

The likelihood that most countries in the industrialised world will see growth in the region of 1 percent and 3 percent this year did not sit comfortably with the exuberance of the recent rallies in assets such as oil and stocks.

The rally in the WTI oil contract took it from $33.98 /b in February last year to a high of $86.84 /b in April 2010.  While a re-pricing was probably unavoidable, it must be said that the economic news, particularly in the US, is not too bad.  Recent US economic data has been sufficiently robust to allow some forecasters to draw the conclusion that the US recovery is now self-sustaining.

The Federal Reserve recently increased its growth forecast for this year to 3.45 percent.  Stronger growth should undermine fears of contagion from the Eurozone debt crisis and will likely allow for a relaxation in some of the market’s indicators of risk and bring further bargain hunters into stock markets and into oil.

This may bring a little support into the near-term outlook for commodities.  That said the reprieve from bad news on the European debt crisis may be short-lived.  On top of that, it is likely that a strong USD will continue to weigh on the prices of dollar denominated commodities.

Risk aversion comes screaming back

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

The Greek fiscal crisis has forced investors to weigh up the risks of sovereign default very carefully.

Funds have moved out of peripheral European bond markets and into U.S. treasuries, JGBs and even (prior to the election result) the UK gilts market. The crisis has also forced investors to reign in their overall appetite for risk.

This is clearly evident across asset classes. Even before the dive in U.S. stock markets on Thursday, the majority of European stock market indices and a large portion of Asian had already given up their gains for the year and oil prices had moved well below their recent highs.

In the FX market safe haven demand tends to boost both the dollar and the Japanese yen.  Currently the dollar’s gains are, unsurprisingly, most marked vs the Euro.  The massive demand for the Japanese yen on the back of the rout on U.S. stocks is reminiscent of previous crisis.

Unless the mood improves noticeably in the next few weeks, risk aversion amongst investors could be sufficient to undermine the pace of the global economic recovery.  Some of the impact of last year’s simulative government and central bank policies could in effect be negated.

U.S. fundamentals are far from perfect. The recent correction lower in the U.S. savings rate suggests that the U.S. will continue to carry a huge current account deficit in the foreseeable future. The budget deficit, which could be above 11 percent of GDP this year, is also potentially a huge problem.

Subject of Europe set to trip Liberal Democrat Nick Clegg

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

Over the past week the British electorate has taken a shine to Liberal Democrat leader Nick Clegg.

Based on just one television appearance the popularity of the leader of the UK’s third main political party has surged to such a degree that the press could not resist the opportunity to draw comparisons with the support attained by orator, statesman and former Prime Minister Winston Churchill.

Clegg’s rise from the political sidelines, while remarkable, does pose at least one problem.  Its speed suggests that the electorate may like the man, but is probably not too familiar with the policies of the Liberal Democrat party.

Among other things, the LibDems are committed to taking the UK into European and Monetary Union.

Not surprising, given the economic crisis in Greece, the party manifesto concedes the current time is not right for such a move.

That said, the party pledge remains that it is in Britain’s long-term interest to be part of the euro.  The UK currently runs a budget deficit/GDP ratio of similar proportions to that of Greece.

UK election boils down to one issue for markets

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

Whether the financial markets will view the outcome of the UK general election as a positive or negative depends almost entirely on one issue: the budget deficit.

According to The Economist, the UK’s budget deficit will balloon to 13.5 percent of GDP in 2010. To give this some perspective, The Economist estimates that the Greek deficit will be a somewhat more moderate 9.5 percent of GDP this year.

Fuelled by recession, last year’s UK government borrowing was the largest ever in peace time.  The deterioration in the budget caused S&P to warn last May that the UK’s debt rating outlook has been revised to negative from stable.

The prospect of a sovereign downgrade would seriously increase the likelihood the UK would suffer a funding crisis.

In other words a lower debt rating would reduce investor interest in UK debt auctions and send yields higher and demand for sterling lower.  In turn higher yields would increase the cost of issuing bonds and divert more taxpayer money into servicing the debt and away from public services.

While there is probably no imminent risk of a credit rating downgrade in the UK, it is clear that budget reform is necessary to kick this threat into touch.

What’s next in EMU after Greece deal?

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

The European Union has finally agreed that an Economic and Monetary Union member country in serious fiscal difficulties will be able to receive bi-lateral assistance from its Eurozone partners as well as draw support from the International Monetary Fund.

Following weeks of discord, it had become politically important that there be a show of unity on how to deal with fiscally errant members.

In this sense the announcement of an agreement was an important step in the right direction.  The proof of the pudding is in the eating, however.

Greece still has to sell a significant amount of debt in the open market this spring and the EU will be hoping that Greece, never mind Portugal or Spain, will not have to tap its EMU partners for a loan.

Greek bond spreads tightened in response to news of the support mechanism, though the initial move in the longer end of the curve was half-hearted with the 10 year still yielding over 300 bps over bunds.

Similarly while the euro performed well after the announcement, EUR/USD has only retraced a small part of its recent falls.   The Greek debt office will almost certainly have to announce another bond sale in the coming weeks.

Better public finance data may be sterling Trojan horse

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

Finally UK monthly public finance data has brought better than expected news.  Not only was the net borrowing figure for February  better than expected but the January data was revised lower from 4.3 billion pounds to just 43 million pounds, taking the total for the fiscal year to date 131.9 billion pounds.

The better numbers mean that Chancellor Alistair Darling is on course for meeting, or perhaps even undershooting, his forecast of 178 billion pounds for the full fiscal year to April.

In essence this appears to be good news, but it requires qualification.  Firstly, these may be better than expected data but they are a far cry from good data.  At this stage last year the borrowing requirement was around half the size at 66.5 billion pounds; meaning that public finances are very much still in a shockingly poor position.

Not only that but there is risk that Darling will use the news that the borrowing requirement is set to come in under his (very high) target to announce some pre-election sweeteners during the March 24 budget.

The huge UK budget deficit (around 12.9 percent of GDP) is already a nasty thorn in the side of sterling and UK financial market sentiment, additional spending would not be welcomed by investors.

The recent falls in the value of the pound vs the dollar are correlated with the fear that the general election (expected to be called early May) will provide a hung parliament.

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.