Some respite for the euro as it came off its 3 ½ year low against the pound after the Bank of England (BoE) slashed  its economic growth projections for the UK economy in its latest inflation report yesterday.

“The outlook for growth presented in today’s Report is weaker than in February, and the outlook for inflation is higher in the near term,” Bank of England governor Mervyn King said, in the opening remarks section of the quarterly inflation report.

The BoE is now forecasting that the UK economy will grow by just 0.8% this year, a more pessimistic projection that its forecast of 1.2% growth made only in its February inflation report.

The BoE’s Monetary Policy Committee (MPC) still believes that a gradual recovery in output together with subdued domestic cost pressures will ease inflationary pressures. However, the report notes that UK output had barely grown for a year and a half and is estimated to have contracted slightly in the past two quarters.

BoE governor Mervyn King said the euro zone sovereign debt crisis posed considerable risks to the UK economic recovery.

In contrast, data out yesterday from the Office for National Statistics showed that UK unemployment has fallen for the second month in a row with a 45,000 drop to 2.63 million claimants in the first quarter of 2012. The UK unemployment rate has fallen slightly from 8.3% to 8.2%.

Analysts had expected unemployment to remain steady and the claimant count to rise by 5,000.

Employment Minister Chris Grayling said the figures indicated a “welcome step in the right direction”.

Dr Howard Archer, Chief UK Economist at IHS, said he suspected unemployment would rise over the coming months as a consequence of extended soft economic activity, heightened business caution, and public-sector jobs being pared substantially.

“Unless the economy starts showing sustained decent improvement, pressure will increase on firms to release some of the workers that they have been holding on to,” he said.

The crisis in the euro zone continues to prompt demand for safe haven currencies with the dollar extending its winning streak on Wednesday as fears mount of a Greek exit from the euro zone.

Worldwide stock and commodity markets continue to register fresh 2012 lows as investors took fright from reports of a sharp rise in bank withdrawals in Greece after efforts to form a new government failed. Fresh elections are expected by mid June in what is rapidly becoming a ‘de-facto’ referendum on European Union membership. The dollar has now enjoyed its longest winning rally since 1985.

The dollar is not only benefiting from so called ‘safe haven’ flows but better than expected US economic data. April housing starts increased by a better than expected 2.6% month-on-month in April while industrial production climbed a stronger than forecast 1.1% month-on-month.

The trading week started with the pound at a fresh 3 ½ year high against the euro as the euro zone sovereign debt crisis continues to dominate the headlines.

The political uncertainty in Greece continues as the parties there have failed to set up any kind of coalition government following the recent general election. The result will almost certainly be a fresh round of elections and the idea that Greece may be ousted from the euro is now being openly discussed in official circles.

Paul Krugman, the 2008 Nobel Prize for Economics winner, wrote yesterday that Greece’s exit from the euro could come as early as June 2012 and could set off a negative chain of events.

European Central Bank (ECB) executive member Jean Luc Coene in an interview with the FT stated that it is now a real possibility that Greece may exit from the euro at some stage. Meanwhile, former ECB and Bundesbank member Otmar Issing was even blunter stating that Greece should abandon the euro zone if it cannot meet its commitments. The ECB to date has emphatically ruled out that very possibility.

According to analysts at credit ratings agency Fitch, a so-called ‘disorderly’ Greek exit from the euro zone could lead to ratings cuts for companies across Europe, especially in the so called periphery.

The main difference between the orderly and disorderly scenarios centres on whether any contagion could be contained. If Greece’s exit is ‘orderly’, that is where policy measures are effective, Fitch says that the fallout would be confined to periphery countries. Otherwise, the repercussions could be worldwide. In either case, the nations that will “bear the brunt” of the widespread market disruption would be Greece, Portugal and Ireland and to a lesser extent, Spain and Italy.

Unsurprisingly, Fitch is of the opinion that any exit, whether orderly or disorderly will be “very difficult” for Greek corporations and is likely to push many close to, or into, default.

The markets also reacted badly to an unexpected fall in euro zone industrial production in March in data released yesterday.

In Spain, its Treasury sold €2.903 billion of 12 and 18 month debt at its latest bond auction yesterday. The 12 month bonds were sold at a yield of 3.099% compared to the prior 2.738%. The Treasury also issued €711 million in 18 month notes with a yield of 3.404% compared to the prior 3.22%. Demand for both was weaker than at previous auction’s.

With the price of German bond yields falling again to set a new record low, the comparative price of Spanish and Italian debt yesterday hit an uncomfortable new euro zone era high.

Further afield, China again lowered its reserves requirement for banks by 0.5% in a further effort to stimulate credit and avoid a so-called ‘hard landing’ for world’s second largest economy. Its large banks will now have to allocate cash reserves of 20% while small- and medium-sized banks will have to set aside just 16.5%.

The decision marks the third reserve ratio reduction in China since November 2011 when it stood at 21.5%. Chinese gross domestic product (GDP) is forecast to expand by around 8% this year, down from the 9% growth registered in 2011. Most analysts are forecasting that the Chinese economy will slow down for a sixth consecutive quarter in the second quarter of this year.

The risk aversion dominating the markets sent worldwide stock markets sharply down with both the FTSE-100 index in London and the Dow Jones index in New York setting 2012 lows yesterday. Oil prices also fell again to record a new 2012 low. This further increased demand for safe haven assets with the US dollar marking an 11 day winning streak now across the board but sent the pound up to register fresh multi month highs against the Canadian, Australian and New Zealand dollars and of course to a multi year high against the beleaguered euro.

The pound remains close to its highest level against the euro since November 2008 despite worse than expected UK retail sales data as the markets continue to focus on the ongoing euro zone sovereign debt crisis and, in particular, Greece. The pound has however now fallen for six straight days against the US dollar in yet another sign of negative risk sentiment in the markets.

Germany cranked up the pressure on Greece yesterday effectively threatening to cancel vital financial aid to the country unless a new Greek government commits to the terms of the country’s bail-out agreements. Ministers in Berlin warned that they would withhold international aid to Greece, a move that would in all probability trigger a fresh default in Athens. There is escalating anger in Berlin over the anti-euro backlash following elections in Athens but the so called troika (EU,ECB and IMF) confirmed that today Greece will receive €4.2 billion euro tranche payment due under the terms of the March bail-out. However, a further €1 billion euro due has been blocked amid uncertainty over the country’s political future. The €4.2 billion tranche payment will allow the Greek treasury to repay a €3.3 billion euro bond on Friday.

The political deadlock in Greece continues after the inconclusive elections held last weekend as left wing, anti-austerity leader Alexis Tsipras failed to form a new government yesterday. The parties that came first and second in Sunday’s elections have now both failed to form a coalition government. Fresh elections are now expected within 3 weeks but the threat of Greece refusing to keep to the bail-out terms has increased the chances of insolvency and the country’s departure from the euro zone.

Elsewhere, Spain’s situation continues to deteriorate. Not only is the country back in recession and was recently downgraded two notches by credit ratings agency Standard & Poor’s (S&P) but Madrid yesterday had to effectively nationalise the fourth biggest bank in the country, Bankia and Spanish bond yields increased over 6% for the first time again adding immeasurably to the pressure on the euro zone’s fourth largest economy.

Data out yesterday from the British Retail Consortium (BRC) showed a sharp decline in UK retail sales in April after wet weather kept shoppers away. UK retail sales fell 1% in April compared to the year before, a major  turnaround from the 3.6% rise seen in March.

Stephen Robertson, Director General of the BRC, said consumer interest in summer fashions and outdoor products was washed away by constant downpours. “Sales held up better for food retailers but customers reverted to winter eating habits, with joints of meat and soups back on shopping lists,” he said.

Dr Howard Archer, Chief UK Economist at IHS, warned there was a very real worry that brittle consumer confidence had taken a significant hit from the news that the UK was back in recession, and this would lead to increased caution in spending.

Lunchtime today sees the publication of the Bank of England decision on UK interest rates and its bond buying program, commonly known as Quantitative Easing (QE). The majority of analysts expect no change on either front following signs that UK inflation is proving more “sticky” than expected. However, with the UK back in recession and worse than expected data last week from the services and manufacturing sectors and weak consumer confidence figures, the ‘doves’ on the Monetary Policy Committee (MPC) may be tempted to increase the QE budget by £25 billion, a move that could devalue the pound.

The euro opened the trading week at its lowest level against the pound since November 2008 after the outcome of elections in France and Greece despite quieter than usual trading as the UK markets were closed for the May Day Bank Holiday.

Voters in France and Greece showed their support for anti-austerity candidates with François Hollande becoming the first socialist president in France for 17 years after his narrow election victory over incumbent Nicolas Sakorzy. Hollande vowed to fight the austerity measures in place and push for a more growth orientated strategy within the EU. On the election trail, he has proposed higher taxes for big corporations and the wealthy against a backdrop of long standing concern about France’s economic outlook amid slow growth and with the unemployment rate already at a 12 year high.

In Greece, voters turned their back on the two main parties, New Democracy and Pasok, and showed strong support for fringe parties that are pro Europe but against the austerity measures in place. The not wholly unexpected post-election chaos in Greece provoked new fears last night that Greece may not keep to its commitments to Europe and may be forced out of the euro. Citibank advised clients that there is now a 75% probability of Greece leaving the euro zone in 12 to 18 months.

To add to euro zone woes, Spain signalled yesterday that it was ready to bail out its ailing banks after Prime minister Marian Rajoy indicated that the Government was ready to intervene to save banks wrestling with the wholesale collapse of the Spanish housing market. Bankia, Spain’s fourth biggest bank, is the first in line for state aid. Spain, is already struggling to cope with an austerity drive that has pushed the jobless total up to nearly 25% of the workforce.

Meanwhile, German officials continue to stick to their stance that the austerity measures in place are non-negotiable and German central bank president Weidmann added that the need to protect the ECB’s independence is paramount and warned that the extraordinary measures currently in place are a response to an exceptional crisis. “We have to make sure that by putting out the fire now, we are not unwittingly preparing the ground for the next one,” he commented, while warning that the current accommodative policy stance is a drug with side effects that become “all the more severe the longer the drug is administered.”

Possibly keeping the pound back from registering even bigger gains against the euro is the potential for the Bank of England to extend their bond buying program, commonly known as Quantitative Easing (QE) by another £25 billion at their two day policy meeting later this week in response to the recent news that the UK  had slipped back into a so-called ‘double-dip’ recession and worse than expected services sector and manufacturing sector growth and weak consumer confidence figures. The political fall-out from last week’s local council elections seems to also be a factor, introducing an element of UK political risk into the equation with Prime Minister David Cameron declaring yesterday that there is “no going back” on the austerity measures introduced since the coalition came in to being following the May 2010 elections. In a rare joint appearance with his Deputy Prime Minister Nick Clegg, they will rededicate themselves and their parties to protecting the country from “the financial storm” of the euro zone sovereign debt crisis and the financial mess inherited from the Labour administration.

Over the pond, US non-farm payrolls increased by just 115,000 in April, disappointing analysts who had forecast a monthly increase of 165,000. However, the unemployment rate in April fell to 8.1% from March’s 8.2%.

With the UK markets reopening this morning and seeming no end to bad news stories, most analysts expect a continuation of the risk aversion theme that has dominated the markets of late.

The pound remains close to the 22 month high set against the euro earlier this week ahead of the monthly European Central Bank (ECB) rate meeting at lunchtime today.

Meanwhile, the deteriorating situation throughout the euro zone aided the rise of both the pound and US dollar as both are being seen as ‘safe havens’ away from the euro zone sovereign debt crisis with the Swiss National Bank (SNB) doubled its foreign currency holdings in sterling in the first quarter of this year as it switched more of its reserves out of the troubled euro. Data out yesterday showed the SNB increased its foreign currency investments in the pound to £14.5 billion in the first quarter compared with just £7.5 billion in the fourth and last quarter of 2011, a trend started in 2009 as the euro zone sovereign debt crisis erupted.

John Wraith, fixed income strategist at BofA Merrill Lynch Global Research, said: “The move by the Swiss to increase their holdings of UK assets, which essentially means gilts, is a powerful example of the haven trade. Some reserve managers [at central banks] are increasing allocations to the UK in part due to concerns about the euro. Despite the problems in the UK with a sluggish economy, reserve managers consider gilts safe as one of the few remaining triple A markets.”

The euro continued under pressure in the markets yesterday after gloomy European manufacturing data and worse than expected unemployment data set the scene for what is likely to be a tense ECB rate meeting today. The ECB is widely expected to keep its key interest rate on hold at 1% but analysts await details on the European growth pact ahead of a summit in June.

Fresh data showed euro zone unemployment rose to its highest level since the euro was introduced while manufacturing output in Italy fell by a bigger margin than had been expected by analysts. Data also showed that Factory activity in Germany, France and Spain also fell sharply.

Unemployment levels in the euro zone rose again in March with jobless figures in Italy hitting a 12-year high. Across the 17 nations that use the euro, the employment rate was up from 10.8% in February to a record 10.9% in March 2012.

The data from Eurostat showed that even Germany saw its unemployment levels rise, from 6.7% to 6.8% in March. Analysts had expected the level to remain stable after six consecutive months of a decline in German unemployment. Yet again the data showed a massive disparity in the economic fortunes of countries that use the euro with the lowest unemployment rates in Austria (4.0%), the Netherlands (5.0%), Luxembourg (5.2%) and Germany (5.6%) and the highest rates were in Spain (24.1%) and Greece (21.7% in January 2012) with Spanish youth unemployment now over 50%.

To add to the euro zone woe, data from Markit’s Purchasing Managers Index showed another decline in manufacturing output throughout Europe in April with the index dropping to 45.9 from 47.7 in March. Anything under 50 denotes a contraction in output and the latest data shows figures close to a three year low.

The pound opened the trading week at a 22 month high against the euro before easing in the afternoon following the release of weaker than expected GfK UK consumer confidence data for April.

Nick Moon, GfK Social Research managing director said “the figures this month will not offer the government any relief in light of the news that the economy has slipped back into recession (…) There are no signs either within the survey or in the recent economic figures to suggest any immediate improvement.”

The euro opened the week under pressure after data showed Spain’s economy fell into recession by contracting 0.3% in the first three months of 2012. The credit ratings agency Standard & Poor’s (S&P) followed last week’s downgrading of Spanish sovereign debt with a downgrade of Spanish banks.

A spokesman for S&P stated “We are lowering our long- and short-term ratings on 11 banks. In addition, we are also placing on CreditWatch negative the long- and short-term ratings on six banks, and only the long-term rating on one bank. We are keeping the ratings on three banks on CreditWatch negative and the ratings on one bank on CreditWatch positive.”

S&P added that it expects to complete its review by the end of May when it should either resolve or update the CreditWatch placements.

Overnight, data showed that activity in China’s manufacturing sector picked up in April which briefly encouraged the markets away from the pessimism from the worsening euro zone sovereign debt crisis.  

Meanwhile the Reserve Bank of Australia (RBA) cut Australian interest rates by 0.5%, the biggest cut in Australia since 2008 in the aftermath of the Lehman Brothers collapse. The markets had expected a cut of 0.25%. The RBA statement pointed out concern over the state of the domestic economy in light of worldwide economic conditions and the slowdown in China which has lessened demand for Australian raw material exports. The pound has opened at a 5 month high against the Australian dollar this morning.

Yesterday was a volatile day in the markets as the pound fell heavily against all 16 of the most actively traded currencies in the market in the morning on the news that the UK economy fell back into recession at the start of 2012.

According to data released from the Office for National Statistics, the UK economic output shrank by 0.2% in the first quarter of 2012. UK GDP contracted by 0.3% in the last quarter of 2011. The economic definition of a recession is two quarters of economic contraction in a row.

Analysts had been expecting the UK to avoid the so-called ‘double dip’ recession and a growth rate of 0.1% in the first quarter had been widely predicted.

“Along with the Bank of England and many other analysts, we are hugely sceptical about the first-quarter GDP data showing contraction of 0.2% quarter-on-quarter. The economy is undeniably still in a hard place, but the evidence overall suggests that it managed to achieve modest expansion in the first quarter” said Howard Archer, chief UK economist at IHS.

Vicky Redwood, chief UK economist at Capital Economics, said the service sector growth figure was the main disappointment as surveys had pointed to services growth of 0.5% or more.

By the afternoon, the pound had recovered the majority of its losses and was back to where it had started in the morning after the markets reacted negatively to a speech to the Committee on Economic and Monetary Affairs of the European Parliament by European Central Bank (ECB) President Mario Draghi.

Draghi indicated that the euro zone economy is stabilising although there are still several downside risks, particularly from the continuing sovereign debt crisis.

“Available indicators for the first quarter of 2012 broadly confirm a stabilisation in economic activity at a low level,” he noted. However, he pointed out that recent mixed data highlighted a “prevailing uncertainty”.

Among the downside risks, he mentioned the “renewed intensification of tensions in euro area sovereign debt markets” and “further increases in commodity prices”.

In this last case, Draghi stated that in his opinion, euro zone inflation would remain above the 2% objective but fall below in “early 2013”.

Finally, Draghi urged euro zone governments to continue working on reforms in order to restore equilibrium to the euro zone economy. He insisted that this “necessitates urgent and resolute adjustment” but was adamant in stating that “clearly, it cannot be the responsibility of the ECB to address these imbalances.”

Overnight and as widely expected, the Federal Reserve in the US kept its interest rate target range unchanged at 0 to 0.25%, a range set in December 2008.

Speaking at his news conference, Fed Chairman Ben Bernanke said US interest rates would be kept on hold for the next two years. Bernanke also said that while the central bank’s assessment of the economy was brighter, he was satisfied with the Fed’s current monetary policy. He also said the central bank is prepared to support growth if necessary.

The euro had opened the day brightly, rising against the pound in particular on the news that the UK has slipped back into a so called ‘double dip’ recession. It was also boosted by successful debt auctions on Tuesday which sent Spanish, Italian and Dutch bonds yields lower. German data reiterating previous growth forecasts also helped.

Elsewhere, credit ratings agency S&P lowered its outlook for India to negative and reaffirmed its BBB- rating.

The pound continues to benefit from the increasing turmoil in the euro zone to register its highest level against the euro in 20 months yesterday. Further afield, poor Chinese manufacturing date sent world- wide stock markets into a spin with the London based FTSE-100 index closing over 2% down yesterday and the Dow Jones index in New York nearly 1% down.

In the currency markets, the pound and the US dollar were the two main beneficiaries of this move towards risk aversion as both are seen as safe havens in current market conditions.

The euro zone continues to dominate the headlines for all the wrong reasons, adding to the pressure on the single currency. In France, Socialist candidate Francois Hollande won a narrow victory against Nicolas Sarkozy in the first-round of the presidential elections. Hollande obtained 28.6% of the votes over 27.1% for current President Nicolas Sarkozy. Polls are already forecasting Hollande the winner with 54% of votes. A victory for Hollande in the run-off on 6 May is likely to spook the financial markets as he has promised amongst other things to increase the minimum wage in France which has been held steady for the last five years, a move that would further erode the competitiveness of French industry and add to the country’s debt mountain. The credit ratings agencies have already warned that France risks a further credit downgrading if they fail to continue to take measures to balance their budget. In a populist move however, Hollande has suggested increasing government spending despite concern about the euro zone’s debt crisis.

In Holland, Prime Minister Mark Rutte has tendered his resignation after failing to reach an agreement with his coalition partners,  the far-right Freedom Party on the nation’s budget cuts who voted against further austerity measures. The coalition had effectively guaranteed the government’s majority for the last 18 months. Holland had to date been considered one of the more stable euro zone economies.
The failed negotiations over the weekend are likely to prompt early general elections in Holland.

Meanwhile, data out yesterday confirmed that Spain has gone back into recession as the Bank of Spain reported that Spanish gross domestic product (GDP) contracted by a faster than expected rate in the first quarter of 2012. According to the published data, national demand fell by 0.9%. As Spanish GDP also fell in the fourth and last quarter of 2011, this has resulted in two consecutive quarters where the Spanish economy has contracted, the technical definition of a recession.

Meanwhile, German Bundesbank president and European Central Bank (ECB) member Jens Weidmann attempted to put a positive spin on events by claiming that not only will all of the 17 current members of the euro remain in the single currency but that other countries could also join up in years to come. In an interview with Welt am Sonntag, Weidmann once again repeated that an exit from the monetary union by Greece wouldn’t resolve its issues and that it would add to the pressure on other euro zone countries. Weidmann has also noted that “the problems in Europe can’t be solved by monetary policy measures”.

The trading week started with weaker than expected Chinese manufacturing data. This provoked a substantial sell off in world stock markets which was later exacerbated by the deepening problems of the euro zone.

In the currency markets, this provoked a move away from high yielding risk based currencies provoking a sell-off in the Australian and New Zealand dollars where the pound now stands at multi month highs against both of these currencies.

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The pound received a big boost yesterday, sending it to its highest level against the euro since August 2010.

Firstly, the Office for National Statistics (ONS) reported the first monthly fall in the number of people unemployed in the United Kingdom since May 2011. The data showed a fall of 35,000 in the three months to February. That saw the UK unemployment rate fall by 0.1% to 8.3%.

Secondly, the minutes of the Bank of England’s (BoE) Monetary Policy Committee (MPC) meeting of 4 and 5 April were published. Most analysts expected the nine member committee to vote 9-0 in favour of keeping UK interest rates at their record low of 0.5% and 7-2 in favour of keeping the asset purchase program unchanged at £325 billion. Instead, we had a 8-1 vote on QE with arch-dove Adam Posen turning hawkish and voting for no change.

The MPC opted to keep the status quo in the face of stubborn inflation as evidenced by the small rise in the CPI rate of inflation reported earlier this week.

Vicky Redwood, Chief UK Economist at Capital Economics stated “We still think that more asset purchases are likely later this year as the economic recovery disappoints again. But the chances that the MPC will pause in May are increasing.”

Meanwhile, the euro remains under pressure as worries mount ahead of another Spain’s bond auction today as the euro zone’s fourth largest economy struggles to deal with its dire financial situation. The Spanish treasury will auction up to €2.5 billion of 2014 and 2022 bonds and markets will be keeping a close eye on the yield and whether demand is strong. If yields exceed 6% again, as they did at Monday’s auction and/or demand is slack, this could rattle an already fragile market sentiment and put further pressure on the euro.

The International Monetary Fund (IMF) added to the note of ‘doom and gloom’ surrounding the euro zone by warning of a possible credit-crunch in the European Union (EU) as European banks continue to deleverage by cutting up to €2.6 trillion in assets from their balance sheets by the end of 2013. The IMF calculates that this may reduce credit supply by 4.4% and have a 1.4% adverse effect on the gross domestic product (GDP) of the region.

“So far current policies have prevented a generalised ‘credit crunch’, but we still anticipate a considerable squeeze on credit which will impede growth,” said IMF Financial Stability Chief Jose Viñals.

Germany meanwhile kept up its hard-line stance as Bundesbank President Jens Weidmann insisted that it is not the European Central Bank’s (ECB) job to solve Spain’s problems.

“I don’t think you will find any colleague (on the ECB Council) who is of the view that the Eurosystem (of Euro zone central banks) is there to ensure a particular interest rate level for a particular country,” said Weidmann. He also stated that in his opinion there are no reasons to discuss a third long-term refinancing operation (LTRO).

Further afield, the concerns about the financial health of the third largest euro zone economy (Italy) and the fourth largest (Spain) caused the financial markets to turn negative and prompted an increase in risk aversion so the pound also registered gains against the high yielding risk based currencies like the Australian dollar, New Zealand dollar and South African Rand.