London Session Recap

The market has continued its move into risky assets. Stocks in Europe and the US started the day on a good note and gold edged lower to the $1,254.60 region. However, currency markets were less bullish. The euro dipped below $1.27 before clawing its way back to $1.2720 and dollar-yen could only climb back to 83.70 after experiencing a bout of weakness early in the morning.

But markets remain at risk. Attention has once again settled on the sovereign debt problems afflicting parts of Europe. Ireland and Greece, in particular, have seen the yields on their governments' debt rise to new highs against the benchmark German bund yield. Not even news that Norway's well-respected sovereign wealth fund was happy to buy Greek government debt placated the market. Sentiment toward Irish debt soured after news that the beleaguered Anglo Irish Bank would be split into a “good” and “bad” bank. This actually raised more questions about the eventual cost to the taxpayer of its bad loans rather than offer any reassurances.

European banks are also coming under pressure as investors weigh how exposed some lenders are to the debt of the Greek, Irish and Portuguese government. European Central Bank member Juergen Stark added fuel to the fire when he told a group of German lawmakers that some German banks will need to raise more capital, especially state-owned banks that were not subject to the European Union stress tests performed earlier this year.

For now, investors should expect uncertain market conditions. Further deterioration in the public finances of Greece, Ireland Portugal and Spain, or signs that these governments are stepping back from fiscal consolidation plans, is likely to send risky assets lower in favour of the relative safety of the yen, Swiss franc, US dollar and gold, which continues to act like an alternative currency. If this happens, the risk to the euro remains firmly to the downside. Investors will be looking at whether the $1.2674 level remains a strong support for euro-dollar.

The Bank of England kept interest rates on hold today at 0.5 per cent, as expected by the market. Asset purchases were also kept steady. In the immediate aftermath of the announcement the pound fluctuated above intraday lows and still looks uneasy. Sterling weakened earlier on news that the UK's goods trade deficit reached a record high of GBP8.6bn in July, much higher than June's GBP7.5bn deficit. The increase in the deficit was due to higher than anticipated imports, which increased by 3.1 per cent on the month, and lower exports, which fell 0.9 per cent. The UK remains a long way off the coalition government's goal of an export-led recovery and fears are growing that weak trade could weigh on growth in the third quarter. This has focused the market on the potential for further monetary stimulus from the Bank of England if growth deteriorates significantly in the weeks and months ahead. Many analysts now think that the Bank is more likely than not to increase stimulus rather than remove support for the economy, which is a negative for sterling in the medium to long-term., and any bounce could be short-lived. The UK's economic recovery is still at risk. Reports that the Bank is mulling over plans to launch quantitative easing part two later this year or early in 2011 have been spurred by a weakening in the survey data for August, which showed that construction, manufacturing and, most importantly, the services sector all experienced a slowdown in growth last month.

There was more news overnight that the global economy is experiencing a two-speed recovery. The release of the Fed's Beige Book survey last night said the economy showed “widespread signs of deceleration” and pointed to regional economic weakness, especially on the East coast. This compared with Australia. Overnight, it was announced that the jobs market continued to grow in July, pushing the unemployment rate down to an enviable 5.1 per cent. This has increased speculation that the Reserve Bank of Australia will raise interest rates further before the end of the year. The news rubbed off on the Aussiue dollar, which extended its good weekly run against the dollar. By mid-morning in the London session Aussie dollar-dollar was trading at $0.9255.

In another sign of slowing global outlooks, the OECD today revised lower its forecasts for the major developed economies, estimating a 2H 2010 G-7 growth rate of about 1.5% vs. their earlier forecast of 1.7%. The OECD cited the slowdown in the US as the principal factor behind the downgrade and noted that it was unclear if the slowdown was temporary. In another about-face, the OECD also suggested that stimulus measures may need to be extended and increased, in contrast to earlier calls to move to fiscal restraint. While noting that the global slowdown was ‘more pronounced' than expected, the OECD is still not expecting a return to recessionary conditions in the G7 overall.

Economic data out later:

A slight improvement in the US trade deficit is expected later this afternoon to -$48bn for July. However, last night's comments from Treasury Secretary Geithner on the slow pace of Chinese renminbi appreciation suggests that the US remains on high alert for any signs that the currency of its main trading partner is stalling.

Initial jobless claims: expected: 470k (472k previously)

Canada Housing starts, August: (exp: 184.5k)