Bill’s Update

Overnight markets are again characterised by a combination of independent EUR weakness and generally diminishing appetite for risk. Although off the low ($1.4015), EUR/USD is still 100 pips down from Friday’s close. Ostensibly, EUR weakness is attributed to the limited credibility of Friday’s bank stress tests and is mirrored in wider peripheral spreads (Italy +13 bps; Spain +20 bps). More generally, equities are soft (US futures -0.6%), leaving JPY the top performing currency in G-10, with USD not far behind. SEK is the worst performer, though this has more to do with general risk appetite than the Riksbank minutes, which added little to the policy debate. White House and Republican leaders appear to have made little progress over the weekend in striking a deal to raise the debt limit, which is also weighing on risk sentiment. The House plans to vote on July 19th to increase the debt ceiling. Press reports suggest that President Obama has already moved to the centre in the budget debate and if press reports are correct, he is looking for $400bn revenues in a $2.0 trillion deal (20% revenues) or $1.0 trillion in revenues in a $4.0 trillion deal (25% revenues). While the US officially runs out of time on August2nd, a failed vote this week could trigger risk aversion and lead to short-term erratic moves.

The publication of the Eurozone bank ‘stress test’ results turned out to be not that stressful for the banks. A scenario for sovereign debt default was not included in the tests and the assumed write-down of 25% on Greek bonds is way below the current discount of 48% to par for Greek government bonds. So, yet again, it is no surprise that the markets remain unconvinced about the integrity of these tests and continue to take a skeptical view of the underlying position of many Eurozone banks, especially in the ‘core’ where there is significant exposure to both peripheral bank and sovereign debt.

Against this background, EU policymakers risk remaining stuck behind the curve and at the mercy of an escalation in contagion and systemic risk, which could include a ‘Lehman-style’ bank bust. As Wolfgang Munchau points out in the Financial Times, “this is a systemic crisis of a monetary union that refuses to be a fiscal union.” Indeed, the ongoing increase in Eurozone bond yields together with widening spreads is a reflection of the financial markets’ concern that events are moving too quickly for policymakers. Italy is now in the spotlight and as 10-year yields head higher, the markets understand that the aneamic GDP growth rate that Italy has experienced over the last decade is insufficient to finance deteriorating debt dynamics. Economic growth is likely to be insufficient to generate the tax revenues required to pay coupons to bondholders. This is the road to insolvency.

GBP: July Rightmove prices fell 1.6%, the first monthly decline this year. Annual inflation fell from 1.1% to 0.1%. In terms of the MPC Minutes, a downside surprise to CPI and further deterioration in sentiment in the Eurozone sovereign-debt markets since the July meeting will leave the record of members' views looking slightly out of date. As for the Public Finances, the first 2 months of the new fiscal year do not look promising, but the fiscal year is still too young to draw any conclusions on whether the government is on track with deficit reduction.