-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.

The upward correction of the value of the euro vs the U.S. dollar since early June this year may have given the impression that the debt crisis that has been weighing on the euro all year has started to dissipate.  Throughout this period, however, many indicators of risk have continued to flash warning signals and it is quite possible that the overall level of anxiety in financial markets may again be taking a turn for the worse.

The recovery in euro/dollar between June 7 and June 21 coincided with an improvement in the tone in equity markets. While both of these events have helped to massage investor confidence, Libor has remained elevated compared with its levels at the turn of the year and the cost of insuring bank debt has remained extremely high.

Suspicion and uncertainty about the level of bad debt in the banking sector, specifically in Europe, refuses to go away. In order to head off concerns about non-performing loans, the Bank of Spain recently agreed to publish the results of stress tests on its banks; a move which forced the ECB into promising that the stress tests on 26 of the Eurozone’s banks would be published.  Greater transparency had been demanded by the markets and is widely welcomed by investors. That said there is an obvious caveat to the publication of stress tests insofar as it does not guarantee that the news will be all good. The coming months could be a testing time for the European banking sector.

The President of the Banque de France, Christian Noyer, recently warned that some banks (in Europe) were already having difficulties raising capital. This was followed by reports suggesting that some banks in Greece, Ireland, Portugal and Spain were particularly reliant on the ECB for funding. Faced with the expiration at the end of June of the ECB’s 442 billion euros, 12 month loan, nervousness may soon rise some more.

To make matters worse, the Bank of England is claiming that if UK banks do not quickly raise 750-800 billion pounds in order to refinance their borrowings, the economic recovery may be at risk. Despite reports that the Spanish property  market may yet see prices fall by another 30 percent and related concerns about non-performing mortgage debt, the Spanish government has recently issued reassurances on the health of its banks.

The Irish regulator is expected to have completed stress tests on Ireland’s three nationalised banks by September; the Irish taxpayer having already paid a heavy price to avoid bank collapse. Given that sovereign balance sheets in general can ill afford to further support the banks, investors are likely to stay wary. It will be a brave investor that chooses to take on an aggressive long euro position in this environment.

-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.

-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.

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

It is generally agreed that if EU officials are to reinforce their commitment to the euro then the Eurozone’s fiscal Stability Pact will have to be strengthened.

The Greek crisis clearly illustrates why the maintenance of fiscal prudence is a prerequisite to a smooth running monetary union.

EU officials are no doubt currently chewing over a number of proposals as to how the Stability Pact may be tightened.

This, however, is another case of locking the stable door long after the horse has bolted.  To make up for the lack of budgetary prudence exercised by some EMU members in recent years, others are now being required to guarantee their debt.  This may work in a federal system but in Europe it is running up against that critical issue of sovereignty.

Germany is faced with having to contribute a whopping EUR123 bln to the EU/IMF EUR750 bln European Monetary Fund.   German tabloids have not held back from venting their dismay.

The results of the May 9 regional election in North Rhine Westphalia also captured the doubts of many Germans towards what has been termed by the press as a ‘transfer fund’.

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

If a gauge is needed to measure how concerned investors are at about sovereign default risk, we need look no further than the price of gold which has made fresh all time highs this week.

Assets with intrinsic value are in demand.

U.S. Treasury debt has also fared well on the back of safe haven buying over recent weeks; it is possible that the dollar could be entering into a renewed period of broad based strength as a consequence of risk aversion.

However, the solid demand for U.S. debt has not prevented the US authorities being wary about the risk of contagion from the European fiscal crisis;  after all the US budget deficit may hit 11 percent of GDP this year which is not too far behind that of Greece (at 13.6 percent).

President of the Federal Reserve Bank of St Louise James Bullard warned this month that Greece’s sovereign debt crisis was spreading and posing risks to the US economic outlook.

Clearly the Greek crisis has shaken both investors and governments across the board.

-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.

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

Next month’s UK general election is not the only one of significance in Europe. There is the possibility that the German regional elections in North Rhine-Westphalia on May 9 could result in the end of the CDU/FDP government’s majority in the upper house of parliament.

While this would not alter Angela Merkel’s status as Chancellor, lessened support would make it more difficult for her to implement planned tax cuts and health services reforms. Fear that she may lose support in NRW is currently delaying the transfer of a German loan to Greece. In turn this means the markets are bracing themselves for a possible default in Greece; an event which could change the present composition of the Economic and Monetary Union of the European Union.

German popular opinion is firmly set against the notion of providing loans to Greece; although Germany as the largest EU economy is obliged to lend around 8.4 billion euros to Greece very soon to help the latter avoid default. While the election in NRW will not be fought on the subject of Greece it does give an added edge to concerns about lack of fiscal manoeuvrability in the region.

NRW has had to issue a record 27 billion euros this year. Over the past 10 years or so the amount of debt per capita has soared. This increase in debt and the possibility that the level of local services will have to be cut to meet fiscal consolidation targets does not sit happily with the notion that German taxpayers may have to make funds available to Greece.

Andreas Pinkwart, the Deputy Leader of the government’s junior coalition partner the FDP has described the prospect of a German loan to Greece as a “slap in the face of German employees”. It is unlikely that sentiment within the cash strapped economies of Spain, Ireland and Portugal has warmed to the topic of a bailout for Greece either.

Germany’s unwillingness to put its hands in its pockets to prevent a Greece default opens EMU to yet further criticism that it is a deeply flawed system. It has been clear for some time that the Stability Pact provides inadequate fiscal controls but if German pockets prove to have limited depth, then the ability of EMU to muddle its way through this crisis is significantly lessened.

- 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.

- 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.