The ECB’s Smaghi’s has pointed out that a restructuring of Greece’s debt would bring the banking system to its knees.

It is this fear that is most likely behind the ECB’s recent denials regarding the prospects of a restructuring of Greek debt and it is probably this reason why there is a strong sense in the market that Greece will be handed more funds from the EFSF.

The complicated web of bank exposure to peripheral debt is the can of worms that all EU officials are and should be fearful off. Greece may be a small country in an economic sense, but are investors are right to be aware of the fragilities of EMU. Politicians will need to work hard to rally confidence in EMU and in the meantime the EUR will remain vulnerable.

Sterling

The BoE’s Inflation report tomorrow is likely to give the Bank plenty of room not to hike interest rates for many months yet. That may soften sterling but it is unlikely to come as a shock; the market has come around to the view that BoE rates are set to stay low until the end of the year. Since mid-Feb sterling has been pricing in a poor UK economic backdrop.

Now that that the adjustment in rate expectations is complete (in our view) there is less reason to expect EUR/GBP to push higher and sterling has proved itself in recent session as being better positioned to benefit from EUR diversifications trades.

The gilts market has shown signs that it has benefitted from the UK government’s tough stance on the budget over the past year this factor may enhance the pound. Although UK fundamentals are still poor suggesting there is scope for poor economic data to undermine the pound on a 1 to 3 mth view, EUR/GBP may be in the process of changing direction. Key support at 0.8700.

AUD: the federal budget and the risk trade

Strong trade data overnight provided some fresh support for the AUD but there is still lots for Australian markets to focus on today with the federal budget coming up in a few hours (10:30 BST). The government is targeting a return the budget to surplus in 2 years.

However, the deficit for 2010/11 is expected to come in larger than indicated. Tax hikes in addition to spending cuts may have to be outlined to achieve the budget goal. While the numbers on the budget deficit may disappoint, the govt is expected to underscore the increase in jobs made during its tenure (the PM has already been doing this today).

Australian April employment data are due later this week. While these numbers have the potential to bring further support for the AUD upside for AUD/USD is likely to remain tough in the current environment. The decision by the CME to raise oil trade margins has already knocked oil prices.

Given the rout triggered in the silver market recently by a similar decision, commodity markets are likely to remain jittery which will pressure the outlook for currencies such as the AUD and the CAD vs. the USD. That said today’s better Australian trade data suggests potential for further gains in AUD vs. EUR, though the federal budget introduces additional risk for this trade this morning.

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