Dubai fears rattle markets

…. with currencies largely unaffected in London trading although the Dollar edged stronger as market liquidity thinned out. The big movers were the CDS and equity markets with the cost of insuring against sovereign default leaping and equities dropping sharply, led by the banks perceived to have most risk out to the UAE region. Overnight analysis of the situation threw up only less certainty and none of the data produced has actually diminished the possible risk to global stability.

This morning, there has accordingly been a rush into risk averse investments ie the Dollar, with gold, oil and equities all dropping sharply as market participants both bank recent gains and hedge against further bad news. The ongoing Dubai restructuring story, combined with recent restructurings in Kazakhstan and Ukraine, raises questions over the quality of sovereign support for quasi-sovereign names. The risk is that in the aftermath of this, rating agencies take a less generous interpretation of sovereign support and we see a wave of quasi-sovereign downgrades. Investors will then demand a higher risk premium for holding assets of those quasi-sovereigns without explicit sovereign guarantees. Hence, developments in Dubai have broader market resonance and the CDS market has continued to react negatively with spreads widening dramatically, especially those of the less well thought of sovereign names.

At least the Japanese authorities can breathe a sigh of relief (for now anyway) as the return of Dollar appetite has bounced $/Yen from its 14-year low by 2 1/2 % – it remains far too strong for the Ministry of Finance’s liking though and if you were a betting man, you would put money on the Bank of Japan using this change in direction to ‘encourage the move’ by the odd bit of foreign exchange dabbling. The Japanese weren’t the only country whose Central Bank was pleased to see a return to Dollar holding. Both Australia and (especially) New Zealand have been most vocal over the last few months with regards to what they perceive to be the unwarranted strength of their currencies. The Kiwi $ weakened to a near 6-month low and the Aussie also soften.

A return of confidence in the global recovery will quickly create the mood for a return to riskier investments and on that basis, a weaker Dollar once more. It probably won’t happen today and more than likely, not for a couple of weeks but the markets tend to have short memories and once liquidity builds up again the current levels will be seen to have good value. Long term risk takers tend to shun illiquid markets leaving the arena to the intra-day traders hence the danger today is that stop losses and technical signals will be targeted creating overly volatile swings. There is of course the chance, with most of the US again on holiday that market players get bored and make an early break for the door ….. Sterling has suffered a bit in the above melee on the back of UK banks assumed to having the largest exposure to the UAE region and a source yesterday suggesting that Alistair Darling will downgrade his 2009 UK growth forecasts at next month’s pre-budget statement. An overnight assessment of the UK banks’ ‘loan’ exposure to the UAE comes up with figures that show that the UK has over 50% of the European total and considerably more than any other nation’s total. This, remember, is only a loans total and does not include any capital markets exposure…. In US$ billions: UK 49.5, France 11.3, Germany 10.2 and the US 9.9 – no wonder Sterling reacted worse.

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