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Greece continues to capture the headlines with agreement expected today on formation of an interim Government and likely announcement of new elections as soon as 10 June. Meanwhile the first meeting between Merkel and Hollande resulted in a joint statement pledging commitment from both to keep Greece in the euro with introduction of “growth measures” subject to adherence to austerity plans.

Growth in the Eurozone stagnated in the first three months of this year compared with the previous quarter, with nil growth. Markets were forecasting a further contraction but stronger than expected growth in Germany, narrowly helped prevent the Eurozone slipping back into a technical recession.

Back in the UK, the goods trade deficit stayed largely unchanged in March despite a rebound in exports as imports also grew to record levels. The deficit was £8.6bn in March with the export growth driven by sales of pharmaceuticals and cars to USA, China and Germany.

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Political risk events continue to dominate in Europe. The political deadlock continues in Greece although a Greek exit was not discussed at the Euro group meeting held yesterday, nonetheless, suggestions that Greece will leave the euro gained momentum leading to the EU Commission issuing a statement hoping that Greece would remain part of the euro zone. There are now signs that the political impasse could now prompt new elections in June. In this context the euro’s downside momentum is likely to gain traction.

March UK Trade Balance this morning is expected to show some improvement. Indeed the data would be welcome news following February’s widening as exports fell and imports remained relatively unchanged. Indeed total goods deficit showed a widening to GBP-8.8bn while services (which remain in surplus) narrowed slightly from GBP5.382bn to GBP5.376bn. Overall February’s disappointing data may prove to be a blip and put down to the extremely cold weather during the month. If this is indeed the case and an improvement is borne out in today’s data we believe this would be enough to keep net exports contributing to GDP.

A busy day today economic activity-wise from the US with the releases of April Retail Sales, CPI, May Empire Manufacturing, Business Inventories, TIC flows and May NAHB House Market Index. The USD continues to find support despite the less than perfect performance from stock indices and the negative news on an American banks’ risk management failure leading to $2-3bn loss. Nonetheless this afternoon’s releases will be the key focus initially before thoughts turn back to the Europe.

Elsewhere, Australian Central bank minutes were released overnight and there was no suggestion in the minutes of an imminent rate cut following the recent 50bp.

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From The Economist Online May 11th 2012, 0:22 by A.P. See original article

As the Economist argues in our briefing this week, a Greek exit from the euro zone would not just be chaotic for Greece itself but would also invite questions about the status of Portugal, Ireland and others. So what would policymakers have to do at the moment of a Greek exit to persuade investors and depositors that Greece really was the exception proving the rule of euro unity?

It would not be enough to spout reassuringly about togetherness when the irreversibility of euro membership had just been disproved. A credible commitment to mutualise the debts of remaining euro-zone countries would probably do the trick, but it is hard to see how such a pledge could be made credible enough in the near future. There is no consensus among Europe’s elites that this is the way to go; and the political journey to that destination would rightly require parliamentary votes and refererendums.

Assume, too, that a Greek exit would be done suddenly and quickly to prevent people there from moving money out of the country ahead of a redenomination. The lesson to others would be move first, ask questions later. The onus on policymakers would be to offer concrete reassurance about other countries, effective immediately.

For Portugal and Ireland, which do not have to worry about the response of the markets, a strong signal of commitment to their membership would be an extension of their current programmes and/or a reduction in interest rates charged by their official creditors. That would be a reward consistent with the message coming out of Europe that the Irish and the Portuguese are more serious about reform than the Greeks. But it would also come at the same time that an ostracised Greece would be about to repudiate its official debts. Euro-zone politicians would be handing over more money to peripheral economies at the very moment they were being handed losses on loans to a peripheral economy.

For countries that are still tapping the markets but are vulnerable to a bout of nerves, like Spain and Italy, the ECB’s bond-buying programme in secondary markets provides only limited reassurance. A broader commitment from the ECB to buy sovereign bonds would be a much more comforting signal, but there is no indication that this moment is near. If the ECB would not relax its stance on buying government debt to save one member, why would it do so for another? And again, a Greek exit would undoubtedly hand losses to the central bank, making it less willing to take on exposures to others.

A country like Spain or Italy could conceivably enter a financing programme pre-emptively, taking it off the markets before turbulence from a Greek exit struck. But that would simply raise questions about how much ammunition Europe had left to cope with another country in distress. That leaves the banks. Another burst of liquidity for the banks, an LTRO 3, would provide Spanish and Italian banks with the funds to keep on buying up sovereign bonds. But the cost, for Spain in particular, would be a further deepening of the ties between banks and sovereigns. A better answer for Spain, especially at a time when lenders would be facing more losses on their remaining Greek exposures, would be for Europe to provide substantial funds to recapitalise weak lenders. It would be best if that could be done directly via the block’s rescue funds, so that money did not have to funnelled via governments, thereby raising the spectre of subordination for existing sovereign creditors. The problem is that direct recapitalisation is not currently allowed. If policymakers could rouse themselves to sort that out, they might also consider allowing the rescue funds to act as deposit-guarantee funds, helping to persuade depositors in vulnerable countries to keep their money at home.

The ramblings above are about hypothetical responses to a hypothetical scenario. But they suggest that it will be hard to provide meaningful and swift reassurances to markets and bank creditors that a Greek exit would be a one-off. The need would be for a display of financial firepower, a demonstration that cash is readily and flexibly available to the next countries in line. The ECB’s liquidity operations aside, that has been beyond Europe’s policymakers to date.

An event laden day lies ahead, kick started with the overnight releases of NZ Business PMI, Japanese Current Account, Trade Balance, China Trade Balance and Australian Employment data. Markets continue to be steered by the European political and sovereign debt crises and in the wake of this bond yield’s continue to remain elevated, notably Spain where yields on the 10 year have remained above the 6% level.

The Bank of England announcement will be keenly awaited despite there being next to no chance of an actual interest rate change, the majority estimates seeing QE remaining at 325bn although interestingly ex Bank of England official, John Gieve noted that the Bank may extend its asset purchases today in what he termed a ‘close call’ decision, seeing little chance of it occurring over a longer period as inflation remained stubbornly sticky – this could weaken GBP a fraction.

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EUR/USD broke below the 1.30 level yesterday as the Greek political crisis rolls on and in this context we expect the EUR to remain under pressure; with French presidential election winner Hollande awaiting inauguration, his pledges to increase state spending and renegotiate the ECB’s independence is unlikely to instil confidence in the market and the longer uncertainty surrounds the formation of a coalition government in Greece the more the Euro will lose support.

Meanwhile Merkel has reiterated her view on deficit financed growth programs, stating that the eurozone needed sustainable growth through structural reforms and a better use of existing support funds rather than short term growth boosting deficit financed programs. She further noted that there was room for compromise with Hollande although would not deviate from her core principles on the matter.

In the UK we focus on the BoE rates meeting with the announcement tomorrow; whilst any move in interest rates is extremely unlikely there is still scope for movement in quantitative easing.

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There are 3 main reasons why we begin this short week with a weaker Euro;

1.Data suggests that the Eurozone could be heading for its third quarter of negative growth.

2.A change of government in France, one that is likely to be less Berlin friendly than its predecessor.

3.The Greek political parties who supported ongoing austerity measures lost their majority rule, in fact leaving the country without a government at all.

Elsewhere the rate of US job creation disappointed on Friday with the April Non-farm payrolls release. Employment rose by 115,000, considerably below markets expectations of a rise of 160,000. However this normally significant data release was well overshadowed by the Eurozones issues.

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As expected, ECB policy makers kept their benchmark interest rate at the record low of 1%. In the associated press conference, ECB President, Mario Draghi, said they still expect a gradual recovery this year but downside risks prevail and the outlook has become “more uncertain”.

Spanish and French government debt sold well at auctions yesterday BUT Spain’s yield on its 5 year bond jump from 3.7%, in the last auction, to a rate close to 5%.

As result the Euro remains under pressure.

Market attention will be firmly fixed on the US Non-farm payrolls today, basically and employment measure. This statistic is widely consider to be the most significant in the economic calendar and nearly always causes a shift in USD.

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USD=1.6161

Overnight, Bank of England Governor King noted that rates would need to stay low for some time while suggesting that it would eventually return to normal levels.

UK saw the release of PMI Construction which came in slightly above expectations at 55.8 while Credit lending and mortgage approvals were a welcome relief from disappointing data yesterday. BoE King’s late comments on rates and the currency failed to support Sterling particularly when he said on the currency ‘We have been able to lower the value of Sterling to make the British economy more competitive’ suggesting that the way the Central Bank had handled Sterling may have been the lever needed to steer the UK away from the problems now faced by the euro area.

Releases of European data left a bitter taste with the PMI’s below expectations and Unemployment continuing to rise. Indeed Germany’s unemployment rate was revised higher to 6.8% due to job losses in April. European markets struggled to hold on to positive mood, reversing initially however not completely capitulating.

Focus will be on the ECB rates announcement and although we expect no changes to rates we suspect that Draghi will be questioned closely as to whether that decision was unanimous and focus will turn to the cautiousness of the ECB in light of recent data and the risks from indebted Eurozone countries such as Spain. Press reports noted yesterday that the ECB had not closed the doors to more measures (which would most likely increase supply of Euro and thus weaken the currency).

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A fall in exports was blamed for a greater than expected decline in the UK PMI manufacturing index yesterday, with its slowest growth this year. The poor in export figures reflect weaker demand from Europe, East Asia and the US, suggesting a fairly broad slowdown thus conditions could get tougher in the coming months for UK producers.

The recent strength of GBP could be threatened, it has owed a lot to the fact that various business surveys have pointed to a more resilient economy than the official GDP statistics but obviously the export figures contradict that.

In stark contrast to the UK, US manufacturing data was very positive. This suggests that US manufacturers will out-perform their European counterparts and will be a boost for the global economy into the summer.

Whilst the EUR remain ‘on the ropes’ USD strengthen against GBP and EUR.

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With public holidays over much of Europe it will be a quiet day for the markets today.

Overnight the RBA unexpectedly cut Australian interest rates by 0.50 which caused the AUD to fall – GBP/AUD now back above 1.5700

This morning’s UK PMI Manufacturing data will be the main source of focus.  It should, in the overall scheme of things, show the UK economy is in a much stronger position than the Eurozone.

An underlying current of concern continues to remain over Eurozone sovereign debt coupled with the upcoming French Presidential and Greek elections. Nonetheless EUR/USD has seen some support, helping the pair to remain tentatively above the 1.32 level.

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