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The euro exchange rate fell to a one month low against the US dollar yesterday

The euro fell to a one month low against the US dollar yesterday as investors sought the safe haven appeal of the dollar and dumped euro zone bonds en masse.

European bond yields surged with the yield on 10 year Italian government debt rising back above the psychologically important 7% level and yields on Spanish bonds breached 6%, setting off alarms across markets. When Greek, Irish and Portuguese bond yields rose above 7%, bail-outs were triggered over the last 2 years.

Even France now faces the prospect of being dragged into the morass with French bond yields rising by more than 0.25% on the day as confidence that European leaders will be able to steer the region away from its debt problems plunged.

In economic news, euro zone gross domestic product increased by just 0.2% in the third quarter, helped by a recovery in activity in Germany and France.

The safe haven appeal of the dollar also helped it to rise against the pound ahead of the Bank of England’s Quarterly Inflation Report. The report is expected to indicate more monetary easing is on its way. Also out over the next two days are UK unemployment and retail sales data, neither figure is likely to do the pound any favours.

The situation in financial markets remains volatile. Analysts at Barclays commented this morning, “In sharp contrast to Europe, US data surprises have tended to be positive since September such that further Fed stimulus is likely reliant on indications that inflation is not an imminent concern. “

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In a rare positive step, Italian ex-European Union Commissioner Mario Monti is expected to present his new cabinet to President Napolitano this morning, just 3 days after his resignation as Prime Minister designate and in Greece, new Prime Minister Lucas Papademos faces a no-confidence vote in Athens this morning. He is expected to easily win, a necessary precondition for approving the first economic reforms which are necessary for the country to obtain the next tranche of financial aid from the ‘troika’ of external creditors. Some of those reforms include pushing ahead with cuts in public sector pay-rolls and reductions in pensions and wages.

As if any proof was needed of the seriousness of the euro zone situation, Peter Bofinger, an economic adviser to the German government who is also a professor at the University of Wuerzburg said last night that the European Central Bank ought to set a cap for sovereign bond yields. “We are in an emergency situation; this isn’t plastic surgery, this is emergency care,” stated Bofinger, at a conference in Frankfurt today. “If worst comes to worst, the ECB has to act before the financial system falls (…),” reported Bloomberg.

Meanwhile, Bank of America Merrill Lynch (BofA ML) reported that investors bought into US and emerging market equities over the last month as they sought refuge from the unpredictable events in the euro zone in their latest Fund Manager Survey (FMS). The FMS showed that 20% and 27% of those surveyed held overweight positions in US and emerging market equities, respectively, significantly up from the 6% and 9% positions seen the month before. In regards to global equities, just 5% of the panel were underweight equities, down from 7% previously.

Unsurprisingly, BofA ML said that the euro zone remains the “least popular region” as gloom within the bloc intensified: “The proportion of Europeans forecasting regional recession has almost doubled. A net 72% of European respondents to the regional survey believe Europe will experience recession in the coming 12 months, up from a net 37% in October,” the survey said.

Chief Global Equities strategist at BofA Merrill Lynch Research, Michael Hartnett, said “Investors are showing belief in emerging market growth and U.S. resilience, which is key to retaining positive global sentiment.”

The firm’s head of European Equities, Gary Baker, said that as long as the problems in Europe don’t spread to the rest of the world, sentiment now seems to be “close to rock bottom”.

Only 25% thought that the world would avoid a recession last month, but that increased to 31% in November, as fears eased. Nevertheless, it is still worrying that the majority have little optimism in the state of the global economy.

Expect further volatility in the markets as poor UK unemployment and retail sales data and a Bank of England growth forecast which is expected to show yet another slowdown in the UK economic recovery to put the pressure on the pound in the short term whilst the ongoing sovereign debt crisis in the euro zone is likely to keep the euro under pressure. The lack of risk appetite is hurting the high yielding currencies like the Australian dollar but aiding the safe haven currencies like the US dollar and Japanese Yen.

Commentary by Tony Redondo

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