Key currencies largely consolidated this past week with the commodity currencies (AUD and CAD) generally outperforming, the EUR trading heavy across the board, and the USD index mostly unchanged on the week. Stock markets similarly held to rather narrow ranges, while commodities saw some upside gains, but remained within the prior week's range. Most JPY crosses recouped some of the prior week's sharp losses, but generally remain lower. While most of the financial media was focused on the Greece/EU drama (more below), we think the real story remains one of faltering global recovery prospects.

On Friday, just before the start of the week-long Lunar New Year holidays, China raised its bank reserve requirement ratio (RRR) another .5% as it seeks to limit red-hot bank lending. (China's banks lent nearly 20% of the total annual lending target in January alone.) Further RRR increases are expected in the months ahead, but the aim is clear—to let the air out of a potentially massive real estate/production capacity bubble before it bursts on its own. The implication for the global recovery outlook is clearly for lower commodity demand and another reduction in growth expectations. Along these lines, euro zone 4Q GDP was extremely disappointing (+0.1% versus expected +0.3% and prior 0.4%; German 4Q GDP flat after prior +0.7%), while Bundesbank president Weber held out the prospect of negative 1Q German GDP. In the US, next week will see key housing data, potentially providing another source of concern to recovery efforts.

In short, just as central banks are laying the groundwork for withdrawing monetary accommodation, key economies are showing signs of slipping back. With stimulus efforts globally winding down (the exception being the US until mid-2010), we think the risks remain biased toward a further pullback in risk appetites, likely leading to lower stocks, commodity prices and another bout of weakness in carry trades (lower JPY crosses). In FX, we are watching the recent range lows as the trigger to further declines after the past week of mostly consolidative price action.

EUR Remains Under Extreme Pressure

EU leaders attempted to put a safety net under the EUR with a pledge to support Greek efforts to reduce its budget deficit, but they stopped short of committing real money to the solution, leaving the EUR twisting in the wind. EU finance ministers will meet on Monday and Tuesday next week and are expected to unveil a more concrete proposal to restore confidence to Greek budget consolidation. However, unless a real money commitment is made, which we think is politically implausible at the moment, we think markets will be disappointed yet again and the EUR will pay the price. Our preferred scenario is that the ministers announce a program of intense monitoring and benchmarking of Greek reform efforts, likely under the technical auspices of the IMF, with a pledge to review the subject in late March, just before Greece needs to access the bond market to replace government debt maturing in April.

In EUR/USD, we and the rest of the market are focused on the pivotal psychological level of 1.3500 down through 1.3450 as the next trigger to further declines. The 1.3750/3850 remains a sell zone, barring any concrete cash pledges from euro zone finance ministers. The past week's price action broke down out of a bear flag consolidation targeting minimum weakness down to the 1.3250/1.3300 area.

Greece in the Headlines

An Emnid poll conducted for a German TV station has suggested that 71% of German taxpayers are against providing additional financial help for Greece. Insofar as taxes are habitually not collected in Greece, the perception that Greece could be free-riding by drawing increased subsidies from the EU rather than embarking on a difficult process of budgetary reform has toughened the attitude of the electorate in other parts of Europe. This has complicated the task of EU officials in trying to find a solution for the Greek crisis. What is agreed is that structural reform will have to take place in Greece. This will be hard and will probably entail a reduction in the wages and numbers of public sector workers. In order to increase the incentive for Greece to follow through with its commitment to reform, the EU is likely to follow the form of the IMF and lay down a process in which progress in achieving reform will be rewarded. The reward may be a commitment to support Greek sovereign debt, though this will have to be within the current EU laws.

The cracks in EMU that have been uncovered by Greece’s fiscal crisis harp back to the issue of whether a monetary union is sustainable in the long run without stronger harmonization over fiscal policies or failing that an undying will to maintain transfer payments to countries in need. EU financial ministers should take steps to impose controls over fiscal policies to avoid another “Greek” issue after the next recession. However, insofar as bringing fiscal policies more closely in line begins to questions the sovereignty of member nations, this has been an issue that EU countries have been sidestepping for decades. Until EMU finance ministers can prove that deficit issues are under control, the EUR is likely to maintain its downward adjustment versus the USD.

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