EU and payrolls: toxic mix for risk
 
The euro has come under heavy selling pressure today as investors take fright on two accounts: firstly, that European Union ministers are becoming more comfortable with the prospect of Greece defaulting on part of its debts and secondly that pressures are spreading from the core to the periphery, especially to Italy, the third largest economy in the Eurozone.

The euro is currently trading at 1.4120, nearly 200 points below Friday’s peak, as EU finance ministers’ gather for a meeting in Brussels. They are set to finalise plans on private sector involvement in any Greek bailout. In recent days the German plan for Greek debt swaps, a more onerous version of France’s plan for voluntary debt rollovers, has gained traction.

This has weighed on bond yields and pushed up the cost to insure the debts of Greece, Portugal, Ireland, Spain and Italy. Worryingly, the cost to insure Portuguese debt has spiked above the cost to insure Irish debt and is moving towards Greece. This is a good test of sentiment, and it suggests that more and more investors believe Greece will default, with Portugal not far behind and problems in Italy continuing to mount.

Whereas in the past EUR/USD has been extremely resilient, we have seen the correlation between EUR/USD and EUR/CHF increase sharply in the past two weeks, and is now at 90 per cent. Since EUR/CHF has fallen sharply there could be further downside in store for the single currency this week, especially as EU bank stress test results are released on Friday.

Although Italian banks are reported to have passed their tests, investors are becoming less tolerant of governments’ with enormous debt burdens like Italy that has €2 trillion of outstanding debt. Even major economies like Italy are coming under pressure, where until recently they would have been spared as peripheral economies took the brunt of investors’ ire.

This must be worrying for officials in the US where discussions between President Barack Obama and Congress to find a deal to raise the debt limit and save the US from default on 2 August broke up without a resolution in sight. The EU debt crisis, US debt ceiling and the global economic slowdown (confirmed on Friday by the exceptionally weak US payrolls number for June) are a toxic combination for risk. Stocks are lower in Europe along with commodities and futures point to a lower open in the US markets.

The dollar is acting like a safe haven even though the US economy is looking extremely weak at the moment and 10-year Treasury yields have fallen below 3 per cent. However, we think the greenback could come under pressure if there is no resolution to the debt ceiling issue. US Treasury secretary Tim Geithner has said that US bond yields may rise as a result of the wrangling between Democrats and Republicans, so expect extreme volatility unless US lawmakers can come up with a last minute solution.

The Aussie dollar got off to a weak start after data out of China at the weekend. Although the trade balance was larger than expected at $22 billion, up from $13 billion in May, imports of commodities slowed. Since Australia is China’s largest trade partner and provides China with the bulk of its raw materials this suggests Australia’s own terms of trade position could come under pressure if Chinese demand slows.

Inflation is also gathering pace, expanding at a 6.4 per cent annual rate in June from 5.5 per cent in May. Inflation and social stability are inversely correlated in China, so the more inflation rises the more concerns there are about social problems emanating from the price pressures. This makes the People's Bank of China’s policy action from here extremely tricky. Since a lot of price pressure is coming from food prices, pork prices in particular, interest rates may not be effective. But if the People’s Bank allows the renminbi to appreciate then exporters will get hurt and this could push up unemployment, leading to even more social unrest. So like the US, China’s economy is looking increasingly fragile.

The pound has traced risky assets lower, but there was more bad news for the UK economy as business confidence slipped to its lowest level since 2009.

Kathleen Brooks is research director at Forex.com.

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