Markets’ call Washington’s bluff

The prospect of a US default before Greece may have seemed unlikely a month ago, but it is now a possibility after the US Congress’ debt talks broke down over the weekend. Greece has just about avoided a default. Moody’s kicked off the week by announcing that it had downgraded Greece to Ca from Caa1. It justified its downgrade by saying that private sector holders of Greek debt were 'virtually certain' to incur losses.

Moody’s sounded relatively positive on the new support package agreed at Thursday’s European Union Summit, adding that it would benefit all Euro-area sovereigns. It added that although the new deal permits an 'orderly Greek default', it shouldn’t cause market turmoil but may require further debt downgrades. At this stage the EU got what it wanted: it has successfully put together the architecture to help troubled sovereigns reduce their debt burdens without triggering mass panic in the markets.

But now that the focus has shifted to the other side of the Atlantic this could be the spanner in the EU’s works. The markets are highly sensitive as the US fails to reach an agreement prior to next Tuesday’s deadline and this is weighing on risky assets. Credit markets in Europe are vulnerable to a further sell-off even after the EU debt deal was passed last week. Already Spanish and Italian bond yields are rising this morning. For as long as the markets’ continue to focus on unsustainable debt burdens then Greek, Irish, Portuguese, Spanish and Italian debt will remain under pressure.

The euro is fairly well supported versus the dollar. The rally triggered by the debt deal on Thursday has been extended to this week. However, it is the result of a weak dollar not people pouring into the single currency. EUR/CHF remains under pressure and is close to record lows once again. The success of the debt deal now rests with Europe’s politicians, who are adept at kicking cans down roads. Germany’s Merkel gave the can a good kick last week when she said she would not put the new plans in front of the German Parliament until after the summer recess.

But although there are still problems in Europe, the US looks in worse shape. A lot of bad news is already priced in for Europe, however, the US Treasury market has escaped a major sell-off. Investors’ are calling Washington’s bluff and still expect a deal to be reached to raise the debt ceiling at some stage this week. A major Chinese newspaper reported that the People’s Bank of China are not worried about a default and believe a deal will be agreed. Investors’ remain nervous, though, and this uncertainty isn’t helping risky assets at the start of the week. It could also do irreparable damage to the US’s reputation in the capital markets, and have just as many long-term consequences as a default.

It will be a jittery week for the markets. Stocks are lower and gold surged to just below $1,620. Above this level $1,650 comes into view. Although it seems like an Armageddon-like scenario to think what would happen if the US defaults, gold would benefit along with the Swiss franc.

The yen has also experienced buying pressure today, which prompted the Japanese finance minister to up his rhetoric and say the government would take 'resolute actions when necessary' to stem the yen’s strength. Japan hasn’t had much success intervening in the markets, and in the current environment it’s difficult to see USD/JPY strengthening in any meaningful way.

Elsewhere, mortgage loans in the UK were higher, but house prices remain depressed according to the latest Hometrack Housing survey, which found that prices dropped 3.9 per cent compared to a year ago this month.

It’s a big week for growth data. The US and UK both release GDP for the second quarter and could deliver some nasty surprises. Weak growth and a debt impasse is a toxic mix for the dollar, which we expect to remain under pressure this week. Also, watch out for Australian CPI data on Wednesday. The Reserve Bank of Australia’s favourite trimmed mean reading is expected to rise to 2.5 per cent per year, up from 2.2 per cent in the first quarter. Producer prices for the second quarter came in line with expectations at 0.8 per cent quarter-on-quarter, and 3.4 per cent annualised, up from 2.9 per cent in the first quarter. Evidence of price pressures still in the system will keep pressure on the Reserve Bank of Australia to hike rates.

Kathleen Brooks is research director at Forex.com

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