London Session: Risk Moderates:Profit Taking Or Something More Sinister?

By Kathleen Brooks, Research Director, FOREX.com

Yesterday's rally in risk has not been sustained today. The markets in Europe have shrugged off better than expected JP Morgan results, which suggest that the banking sector in the US is not as bad as some may have thought. However, the real problems are in the European banking sector, and while there is no solution to the sovereign debt crisis this sector is still extremely vulnerable and may not follow its American counterpart with stronger than expected Q3 results when they report later this month.

Europe is still at the front of the action. Italy is in focus today. Prime Minister Berlusconi is now facing a vote of confidence in his government after the lower house failed to pass budget measures for this year. Political turmoil is likely to ensue since the opposition has said it will not support the confidence motion in the government. Political trouble comes at a dangerous juncture for Italy. It needs to auction EUR55 billion of debt before the end of the year.

Berlusconi addressed parliament today, saying that Italy's debt problems are "from the past" and now is not the time to change governments. However, amidst all of this political turmoil there was one bright spot. Italy auctioned EUR3.5bn of 5-year bonds with an average yield of 5.32% and a bid-to-cover ratio of 1.34. This was an improvement relative to auctions held in August, and 10-year bond yields moderated to 5.79% from 5.88% after the auction. However, this is still a high level and perilously close to the 6% threshold that is deemed unsustainable for such a large debtor like Italy.

Added to that, there may be some splits emerging between the relative branches of power in the EU about how to save Greece. The ECB said today in its monthly bulletin that greater private sector involvement (i.e. haircuts to the tune of 50-60%) could spread contagion and dampen sentiment towards Italy and Spain, while also weighing on the banking sector. On the other hand, Germany is supportive of private sector involvement.

So the scene is set for an interesting summit on 23rd October, when EU leaders will be presented with the EU Commission's 5-point plan to save the Eurozone, which includes bank recapitalisations, a decisive agreement on how to deal with Greece, closer economic governance and reforms to be put in place to boost growth. The markets' recent rally has been propelled forward by expectations of action and results in the next few weeks, so the lead up to the October 23rd summit may be extremely volatile.

However, problems could be afoot. Criticism of bank re-capitalisations plans, considered the lynchpin to the Merkel/ Sarkozy plan to save the Eurozone, have started to emerge. The head of Deutsche Bank said that more capital is not the answer and will only make countries more indebted. The European Banking Authority isn't paying too much attention to this, however. It is proposing that European banks should hold capital that is equivalent to 9-10% of their risk-weighted assets, which, if enacted, would require banks to raise approx. EUR200bn extra capital in the coming months. However, the true figure will depend on what the EBA considers risk-weighted assets and how risky it claims sovereign debt is. In the past it hasn't taken account of sovereign defaults, which has lowered its estimates of bank capital requirements. The markets are unlikely to react well to this if they do the same this time.

Adding to the weaker tone to the markets are the Fed minutes from its September meeting. The minutes showed that the dissenters against more stimuli still outnumber those who are looking for another round of QE. Although QE remains on the table it may not be forthcoming and without deterioration in growth we will have to make do with Operation Twist. Due to the close correlation between the size of the Fed's balance sheet and the performance of risky assets, no more QE has taken the shine off stocks.

Chinese trade data was weaker for a second month, suggesting that Friday's GDP data for Q3 could be weak. The market is currently expecting annual growth to slow to 9.5% from 9.6%. Anything lower than this could weigh heavily on risky assets as China is still seen as the bright spot in the outlook for global growth.

UK trade data was better than expected, driven exports. Export values rose to GBP25.5bn in August- the highest on record. This is the one bright spot in an otherwise gloomy outlook for the UK economy. This supports a weaker pound to try and keep the UK economy out of recession and adds to the argument that QE is a good thing for the UK economy if it depresses sterling.

Elsewhere, watch out for US jobless claims later and momentum may start to build behind the G20 finance ministers and global central bankers' meeting that takes place in Paris this weekend.

Data Watch:

EU Troika evaluation on Greece
EU Constancio speaking
13.30BST (0830 ET) US Trade deficit Last -$44.8 Bio Exp -$44.5 Bio
13.30BST (0830 ET) US Initial Claims Last 401K Exp 400K
14.00BST (0900 ET) UK Posen speaking
14.20BST (0920 ET) G7 Quarterly Global economic outlook published
16.45BST (1145 ET) US Plosser speaking
19.30BST (1330 ET) US Kocherlakota (FOMC Voter) speaking
00.50BST (1950 ET) JP M2/(M3) Last 2.7 (2.2) Exp 2.8 (2.1)
00.50BST (1950 ET) JP Corp goods price index Last 2.6 Exp 2.5