Is The Firewall Strong Enough?

The first part of the week will inevitably be dominated by Monday's EU Summit and continuing talks surrounding the Greek debt-restructuring deal. There has been a significant shift in tone and rhetoric from officials and this will be a key theme over the coming week as Euro-zone leaders are now more confident that the contagion firewall is strong enough to cope with an effective Greek default which is encouraging them to take a tougher stance, especially with the dovish Fed tone also still helping to support risk appetite.

The Greek government and private-sector creditors have reportedly been on the brink of a deal for the past week, but an actual solution has still not been delivered despite all the talk. Even if a deal between the two sides can be reached, there will still need to be approval from the troika. Euro leaders are now more confident over pushing Greece and private creditors even harder with less fear surrounding the repercussions if Greece decides to reject any imposed deal.

During much of December, the tone within the Euro-zone was notably bleak and fearful as credit-crunch and liquidity-crisis fears stalked the European banking sector. During January, the tone has become significantly more relaxed both within central banks and Finance Ministries. There is certainly still very serious concern, but the edge of panic seen previously has eased.

The key to this has been the much more aggressive tone by the ECB, especially with his long-term repo operations to boost liquidity within the banking sector. There was a high degree of fear that the banking sector was on the verge of collapse and the clear implication was that any Greek default would be likely to trigger a full-blown banking-sector collapse.

The ECB liquidity operations have lessened the immediate risks of banking collapse even if the sector as a whole is still in severe danger. There has also been a significant decline in bond yields for Italy and Spain. In this context, there is now a much greater probability that Euro-zone leaders will look to take a different stance and effectively push Greece into default or certainly tolerate any creditor arrangement as being deemed a default. There is greater confidence that destabilisation can be avoided and that efforts can then be focussed on preventing the contagion threat.

There will be a very close focus on Portugal over the coming week. Yields have risen to record highs on benchmark debt and there has also been an increase in credit default swaps to record levels. A further increase in yields would increase the risk of a Portuguese default and severely test the firewall's capabilities. The banking sector also remains extremely vulnerable and there is a high risk that the situation will be misjudged.

As far as data releases are concerned, the focus will inevitably on the US employment data. The monthly payroll data will be released on Friday and the ADP data will be released 48 hours earlier with the jobless claims sandwiched in between. The PMI manufacturing data will also be watched very closely on Wednesday and a solid release looks likely after the regional data.

The potential data impact has certainly been downgraded following last week's Federal Reserve meeting. The Fed and Chairman Bernanke remains determined to maintain a near-zero interest rate policy throughout the next two years. The yield implications will therefore, be very limited even if there are strong data releases. The main focus will tend to be on whether the Federal Reserve's decision and determination to keep policy on full throttle is based on domestic or international considerations. A robust set of employment data would help to ease fears surrounding the US outlook and tend to increase speculation that the Fed's primary short-term concern is the global economic outlook and the Euro-zone contagion threat.

Another important focus during the week will be the Chinese economy as markets re-open following the week-long lunar new-year break. Ahead of the holidays, there was a rally in Shanghai markets on expectations of a further monetary easing by the PBOC.

Policy actions and the equity-market reactions will be very important for regional confidence and risk appetite. If the central bank takes action on reserve ratios or even interest rates, then there will be an important near-term boost to risk appetite, while further evidence of a slump in the property sector would substantially increase the level of fears again. Hope may well triumph over fear in the very short term, although the longer-term prognosis is much less favourable.

The UK PMI release will be important during the week, especially as there has been mixed evidence over the past few weeks. There was a reported 0.2% GDP contraction for the fourth quarter and confidence in the retail sector appears to have weakened sharply, but last month's PMI releases were all stronger than expected. Another solid set of releases for this month would lessen outright recession fears and also help underpin Sterling.