Risk Markets To Stablize Briefly After Steep Sell-Off

Risk aversion dominated markets last week and wold stock markets turned negative for the year as MSCI world index erased all it's gains this year. We're talking about S&P 500 having the losing losing streak since last August. Major European indices fell last week with notable fall in FTSE by -5.5%, CAC by -3.9% and DAX by -4.7%. Greece ASE tumbled as much as -10%. The chance of a Greece exit jumped as political leaders failed to form a coalition government and is heading for new election in mid-June. But the worry didn't stop there.

The deeper concern is indeed in the euro-zone financial sector as a whole as well as all peripherals. Benchmark 10-year Spanish yields jumped to as high as 6.5% during the week, the highest since last November, before closing at 6.25% while 10-year Italian yields close rose to 5.78%.

Risk markets look oversold for the moment and might consolidate in the early part of the week. The Dow and S&P 500 are trying to draw support from the important 55 weeks EMA and attempt for recoveries. EUR/USD is also trying to consolidate above this year's low of 1.2625. But stocks, European majors, and commodity currencies are vulnerable to a deeper fall. Greece will possibly be off the highlight until the next election and focus will be on negative news from Spain and Italy.

A few developments to note, though: Firstly, the yen has caught up and is indeed over-powering the dollar as markets are starting to speculate QE3 again based on financial market turmoils and weak US economic data. Secondly, precious metal has indeed recovered from early selling on QE3 speculation. Such speculations could limit the dollar's momentum to rally. Thirdly, sterling's fate against the euro has somewhat turned since the dovish BoE quarterly inflation report.

In Greece, after all efforts, including that from president Papoulias, political leaders failed to form a coalition government. New election was declared which set for June 17. The anti-austerity Syriza and pro-bailout New Democracy take turn in leading polls. June's election is described as a vote for staying in or leaving the euro-zone. Speculations on the political situation will continue over the coming weeks. But we'd like to emphasize again that no conclusive result is guaranteed from June's election. The situation might just repeat again, creating even more uncertainties for markets.

Meanwhile, Fitch downgraded Greece's long-term credit rating from B- to CCC and cited that it "reflects the heightened risk that Greece may not be able to sustain its membership of Economic and Monetary Union." The rating agency noted that the May 6 parliamentary elections and subsequent failure to form a government showed "lack of public and political support" for austerity and bailout from EU and IMF. And, "in the event that the new general elections scheduled for 17 June fail to produce a government with a mandate to continue with the EU-IMF program of fiscal austerity and structural reform, an exit of Greece from (the euro) would be probable."

In response to the heavy withdrawal of deposits from Greek banks, the ECB announced that it will suspend lending to some of the institutions it does not consider as solvent. The central bank stated that "once the recapitalization process is finalized, and we expect this to be finalized soon, the banks will regain access to standard Eurosystem refinancing operations."

Markets are also deeper concerned with Spain's banking sector. There were reports that Bankia, the Spanish bank that was nationalized recently, received more than EUR 1b withdrawal since last week. Moody's downgraded credit rating of 16 Spanish banks, citing that "banks will continue to face highly adverse operating and market funding conditions that pose a threat to their creditworthiness." The rating agency believed "the Spanish economy has fallen back into recession in first-quarter 2012" and it does not expect conditions to improve this year. The downgrades also indicated that the reforms (including additional provision requirements for banks, availability of government capital injections, creation of a framework for “bad banks" and employment of independent audits) announced by the Finance ministry are viewed as insufficient to stem the problems in the country's banking sector.
 
Also, Moody's downgraded 26 Italian banks to "amongst the lowest within advanced European countries" on "susceptibility to the adverse operating environments in Italy and Europe." The banks are downgrade by at least one notch and for some as many as four notches. All 26 banks are assigned a negative outlook. The rating agency cited that Italy is back in recession and loan demands were weighed down by austerity measures. Banks would be facing deepening loan losses as well as more difficult access to funding. Though, support from ECB has lowered the risk of default for many banks.
 
Regarding the economy, the euro-zone economy turned out to be slightly better than expected in 1Q12. Notwithstanding consensus forecast that the region would technically fall to recession with two consecutive quarters of contractions, the flash GDP data came in flat, compare with 4Q12’s -0.3% drop. Despite the apparently stronger-than-expected growth figure, the upside surprise mainly concentrated in a few countries and more peripheral economies, e.g.: Italy, have confirmed a sharp recession. Investors should remain cautious about the euro-zone economic outlook. While the preliminary data still has a chance to be revised lower, deep contraction might actually be reflected in the second quarter due to member countries’ fiscal consolidation.
 
From US, the April FOMC minutes released overnight indicated that policymakers acknowledged improvements in economic growth but these remained insufficient to change its current accommodative policy stance. While there was slight change in language from the previous meeting, it appeared that the central bank turned mildly more dovish. Overall, the Fed continued to pledge that it would do more if the economy deteriorates further.
 
From the UK the BOE released a dovish quarterly inflation report in May, lowering both inflation and GDP growth forecasts from February projections. Policy makers also cited the worsening situation in the euro-zone would affect the UK's path to recovery and there was a "risk of a storm heading our way from the continent." The central bank revised down its growth forecast for this year to +0.8% from +1.2%. The growth forecast in 2 years fell from +3% to 2.6% in the latest report. As stated in the report, prospects for the country's growth are “unusually uncertain.” Concerning inflation, the forecast in 2 years was revised to +1.6% from previous projection of +1.8%.
 
The RBA released minutes about the rate cut in May, unveiling that the policy makers believed monetary easing is needed to stimulate growth. It’s stated that "growth outside of the mining sector was expected to be below trend in the near-term, affected by the high exchange rate, softer government spending and subdued conditions in the housing market and building industry." Moreover, "with financial markets remaining unsettled, the risks emanating from Europe continued to cloud the global outlook."