Risk reacts badly to Bernanke

Risk has been fairly muted this morning and markets are range bound after Federal Reserve president Ben Bernanke’s speech last night to bankers. He acknowledged that the growth of the economy was weaker than expected, but said that 'Although the jobs market remains quite weak and progress has been uneven, overall we have seen signs of gradual improvement.' This suggests that QE3 will not be forthcoming even if the economy continues to dip. This dented appetite for risk.

Rather than embark on QE3, the Fed president said, 'The Committee also continues to anticipate that economic conditions are likely to warrant exceptionally low levels for the Federal funds rate for an extended period.' He also acknowledged that monetary policy so far (low rates and stimulus) 'cannot be a panacea' the economy’s problems after the worst financial crisis since the Great Recession.

However, reading between the lines, if the economy doesn’t perk up in the next few months as the Fed is expecting, especially  the jobs market, then there may well be a further round of monetary stimulus – it all depends on whether the economy is going through a summer malaise or if there is something more sinister going on.

Risky assets got hit and Bernanke’s comments caused a flight to safe havens. USD/JPY fell below 80.00 and USD/CHF is back around the 0.8350 mark. Stocks are lower as are commodity prices. The dollar is relatively flat as is the euro.

The oil price may well be volatile today as OPEC meets in Vienna. The organisation of oil producers is likely to raise production to try and dampen recessionary risk especially in the developed world. We have heard from the Iranian President of OPEC this morning who said that the Organization is worried about joblessness and high debt levels in the West; however he said the fundamentals in the oil market remain sound. So, while we expect production to be ramped up, we expect it have a fairly negligible impact on the oil price.

Elsewhere, the UK was centre stage earlier this morning after credit rating agency Moody’s said that the UK risked losing its Aaa sovereign rating if either: one, growth slowed; or two, the government strayed from its fiscal consolidation targets. So the chancellor seems to be caught between a rock and a hard place as he comes under increasing pressure to slow down the pace of deficit reduction in the face of a deteriorating growth outlook.

The immediate reaction was felt in bond and FX markets. Longer-term bond yields actually jumped on the back of heightened credit risk; however the pound weakened across the board. While rising yields usually coincide with a strengthening currency, not so when yields rise because of doubts about the safety of a credit rating, which is currency negative.

We expect the pound to grind lower especially versus the euro due to two factors: firstly, the Bank of England seem firmly on hold while the European Central Bank (ECB) is expected to hike rates next month, and secondly, Germany (the largest economy in the Eurozone) has a much sounder financial position than the UK and is not currently at risk from a credit rating downgrade.

Mario Draghi, the head of the Italian central bank and likely next president of the ECB, dominated the airwaves earlier when his response to questions about his nomination from the European Parliament was made public. He said that he urges an element of gradualism in the ECB’s exit strategy, which seems to be in line with the current ECB stance. He also said that there was a high degree of uncertainty in the outlook for the currency bloc’s economy, but he added that he would 'fully respect' the ECB’s price stability mandate. So it looks like Draghi at the helm of the ECB would signal more of the same.

Greece’s financial problems rumble on. A Greek government spokesman said that the government’s medium-term fiscal strategy and privatization plans would be voted on by Parliament at the end of June. This may well delay a vote by EU leaders on 20 June when they meet to discuss a second round of financial support for the nation.

However, there seems to be more traction on the view that any future financial support for Greece would include private sector participation. It seems like the only form of private sector participation acceptable to the ECB would be voluntary debt rollovers – so holders of Greek bonds would simple buy more bonds when they reached maturity. It’s hard to see many investors actually wanting to do that but it would technically avoid a default and thus should keep financial markets calm.

The German Bank Group, an association for the sector, said that a 'soft restructuring' of Greece would still be painful. He also said that any type of restructuring must be voluntary for private investors, and should only be an end resort. He also said that a Greek bond maturity extension could be one option for a restructuring. The fact that he mentioned this as an option suggests that this could be the only solution acceptable to Germany’s banks, which are exposed to a significant chunk of peripheral banking and sovereign debt.

So far the euro has weathered the storm quite well. FX and credit markets seem to be warming to a solution to the crisis that doesn’t involve the word default, even if the details remain hazy. Greek bond yields are off their highs and the euro remains well supported above 1.4650.

Part of the euro’s strength is also the economic performance of the stronger member nations. GDP expanded by a healthy 0.8 per cent in the first quarter and was led by government spending and investment. There was some worrying news in the report including weak personal consumption and the fact that fiscal consolidation measures across the currency bloc this year could limit government spending and hurt growth going forward. Likewise, German industrial production fell by 0.6 per cent in April, more than expected; suggesting that Germany’s manufacturing rebound could be coming off the boil.

Kathleen Brooks is research director at Forex.com

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