Conviction is a vital element in sustaining market and political confidence and this will be a pivotal week ahead for Euro-zone faith following another day of torture on Friday. Standard & Poor’s decision to downgrade France and Austria can hardly have been a surprise as markets have been on high alert for the announcement throughout the past few weeks, but there will still be important implications at the economic and political level as the cost of Euro-zone support continues to increase. Market talk will focus on the risks of a further escalation of the Euro crisis, although it is doubtful whether selling offers immediate value at current levels.
The decision will increase political pressure in both France and Germany while the EFSF will find it even more difficult to attract funds given that its own ratings will be in jeopardy. There will tend to be a hardening of political rhetoric in Germany and it will be even more difficult for Chancellor Merkel to convince a sceptical electorate that the Euro is still a project worth pursuing as the economic costs to Germany continue to increase. The downgrade is inevitably a substantial setback for French President Sarkozy’s re-election hopes and his conviction to the Euro-zone project will come under severe pressure if opinion poll ratings deteriorate at home.
The announcement that Greek debt negotiations had broken down was over-shadowed by the French ratings announcement. Nevertheless, it is extremely important and nudges Greece ever closer to a hard default. Brinkmanship is an inevitable threat in these negotiations, but there is a growing threat of miscalculation on both sides and a slide to imminent default as Germany and the IMF will have even greater doubts over the wisdom of committing more funds. Does the Greek government really have the necessary conviction to follow austerity policies through? This week may force the government to make the ultimate choice over continuing Euro entry.
China will be an important focus during the week with the latest GDP data due on Tuesday followed by the flash manufacturing PMI data on Friday. With China on holiday for the Lunar New Year celebrations the following week, this is an extremely important week for the Chinese government and central bank. There is a strong possibility that further reserve ratio requirement cuts will be announced to underpin sentiment ahead of the Holiday season and this would help underpin international risk appetite.
There are a series of important UK economic releases with the latest inflation data on Tuesday likely to be the main focus of attention. Inflation edged lower in December and there should be a further sharp reduction at the start of 2012. Principally, this will reflect technical factors as prices rose sharply at the beginning of 2011 as the sales tax was increased. This increase will come out of the annual calculation in January and there will be an important impact in cutting the inflation rate. There has also been some downward pressure on energy and transport prices while retail discounting has also been a very important factor.
There is, therefore, a good chance that there will be a weaker than expected release. This would provide a fig-leaf for the Bank of England to justify further quantitative easing within the next two months, although it remains the case that inflation control has long been abandoned as the battle to keep the economy afloat has taken precedence. The latest unemployment data will be released on Wednesday with the important Christmas retail sales data due out on Friday.
The US economic data releases will be important, especially as they will set the tone running into the first Federal Reserve FOMC meeting of 2012 which is due the following week. Although the US economic data has generally shown evidence of improvement, there has still been dovish rhetoric from several Fed members and some FOMC voters are still looking for additional easing.
The New York PMI index on Tuesday and Philadelphia Fed index on Thursday will be important gauges of manufacturing sentiment with the housing data also due on the same day. If Fed Chairman Bernanke is seriously considering fresh stimulus measures, then there are likely to be hints of this during the forthcoming week. Long dollar positions are still at near-record levels according to the latest IMM speculative positioning data. Any hint of further Fed easing would leave these positions heavily exposed and subject to a sharp reversal.
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