Politics Drives FX , Safe Havens Sought

The events in the Middle East and Northern Africa are the main spur of market action. The position adjusting pressures that had sent the euro nearly two cents from the high seen earlier yesterday ran into hawkish comments from ECB's Mersch that spurred the short-covering bounce in mid-morning turnover in Europe. Mersch hinted that the ECB may raise its inflation forecast and in effect adopt a tightening bias, within its "no pre-committing" framework.

Yet in some ways Mersch's comments are not new in substance and recent official comments have played up the upside risks to inflation. With oil prices at two year highs and given the ECB's penchant for viewing higher oil prices as inflationary, the ECB's rhetoric has taken a more hawkish turn of late.

While events in Libya are dominating considerations at present, the "jasmine revolutions" are sweeping across the region. Both Libya and Bahrain were downgraded yesterday (Fitch and S&P respectively). S&P followed up with a cut of Libya's credit rating today and placed it on negative watch. News reports suggest Egypt has asked the EU for debt forgiveness. The events in Egypt may have helped embolden others and the unrest appears to be spreading, with the Ivory Coast, being impacted today.

These political events are having an economic impact. First, it is sparking an oil shock that could act as a headwind to the world economic recovery. Second, it is exacerbating the broader commodity shock directly and indirectly. Note that modern agricultural production is very energy (oil and natural gas) intensive. Third it is prompting a retreat in equity prices, which impacts household net worth, consumer confidence and the cost of capital.

Two other events are on radar screens today. Moody's lowered its outlook for Japan's AA2 rating to negative, citing concern that its fiscal policy is not strong enough to stabilize the debt/GDP ratio. However, the rating agency acknowledged that the world's third largest economy does not face a funding crisis in the near/medium terms. A decision on Japan's rating is unlikely to be made before the government unveils its tax and welfare package near midyear.

Although Japan funds its budget with domestic savings, many economists project that at some point in the second half of the decade, domestic savings will not be sufficient. A faction within the ruling DPJ is aiming to block the government's budget plans and it will be interesting to see if the suspension of the rival leader Ozawa has much impact. While Japanese equities fell in line with the region, Japanese bonds seemed largely unaffected by Moody's decision, as safe haven considerations dominated. The price of credit default swap (5 yr) rose a couple of basis points.

New Zealand's second largest city, Christchurch was hit by a 6.3 (Richter scale) earthquake that the Prime Minister called "utterly devastating". This has sparked a 2% drop in the New Zealand dollar as the market extrapolates policy consequences, removing a good chance of a rater hike that was previously discounted.

The European debt crisis remains unresolved. Of note, the head of the European Bank for Reconstruction and Development seemed to suggest what many in the markets have suspected: a restructuring of Greek debt is nearly inevitable. Mirow told a German paper that Greece cannot bear debt/GDP of 150%.

EC and ECB officials continue to visit Portugal to assess their public accounts and strength of the financial industry. Remember Portugal's debt problems are not (yet) concentrated in the public sector, but rather private sector. This means that although Portugal is reporting that its deficit reduction program is indeed being implemented, the market is giving the country little reprieve.

On the other hand we note that there is goodwill building toward Spain and this is being reflected in a de-coupling of Spanish bonds from Portugal. As Ireland got assistance last year, Spain and Portuguese bonds were correlated 0.8 (on a rolling 60 day basis) that correlation is below 0.2 today. That said, it appears to be rising in recent days. The Irish election on Friday is the next major (scheduled) event risk.