Debt crisis continues

It was a turbulent day for markets yesterday, as they ponder over the escalating European debt crisis and the evident failure to reach agreement on raising the US debt ceiling. As it stands Europe’s crisis looks to be going from bad to worse, as suggested in the record breaking higher costs of French, Italian and Greek debt yesterday. The situation reached breaking point as Italy suspended trading on government and corporate bonds following last weeks release of EU stress tests. The panic led to billions wiped off the value of European banks with the UK alone losing GBP6.3bln with Lloyds falling 7.5%, with RBS and Barclays losing 6% and 3.7% respectively.

Despite Italy grabbing the headlines attention is still very much focussed on Greece and reaching agreement on a second bailout for the country, with further discussions at the special EU summit on Thursday. The hot issue remains the extent of private sector participation in any debt restructuring. The assessment to improve the flexibility of the EFSF bailout fund to embark on debt buybacks has not helped. As a result contagion risks to other countries in the Eurozone periphery are at a heightened state. In spite of this the EUR has shown a degree of resilience, having failed to sustain its recent drop below 1.40 versus USD and currently trades at 1.4156. A possible reason for the EUR’s bounce is that the situation on the other side of the pond does not look much better. Murmurs of QE3 in the US and the stalemate between Republicans and Democrats on budget deficit cutting measures tied to any increase in the debt ceiling are limiting the Greenback’s ability to profit from Europe’s distress. Furthermore, more weak data including a drop in the Empire manufacturing survey and a drop in the Michigan consumer sentiment index to a two-year low, have added to the worries about US recovery prospects.

Against this background risk aversion will remain elevated, supporting the likes of the CHF and JPY while the EUR and USD will continue to fight it out for the winner of the ugliest currency contest. Assuming that a deal will eventually be cobbled together to raise the US debt ceiling (albeit with less ambitious deficit cutting measures than initially hoped for) and that the Fed does not embark on QE3, the EUR will emerge as the most ugly currency, but there will be plenty of volatility in the meantime.