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Dollar to drop on S&P move

By Emelia Sithole-Matarise | Reuters – 1 hr 8 mins ago...

http://news.yahoo.com/dollar-drop-p-move-saf-haven-demand-seen-044626271.html

LONDON (Reuters) - The dollar may fall and Treasury yields rise on Monday in response to the United States losing its top-tier credit rating from Standard & Poor's but any selling is likely to be tempered by the euro zone's escalating debt crisis.

Equity markets' likely reaction was indicated by a drop of more than six percent on Sunday in Tel Aviv stocks, one of the first to open globally after S&P on Friday cut the U.S. long-term credit rating by a notch to AA-plus from AAA.

Investors will be all the more likely to withdraw to safe havens, such as the Swiss franc, the yen and gold, if euro zone officials cannot stem concern that their debt crisis risks engulfing Italy, the bloc's third largest economy, whose government bond yields have soared to 14-year highs.

"The real effects of this (U.S. credit rating downgrade) will take time to show through but a weaker U.S. dollar and marginally higher yields are likely," said Charles Diebel, a strategist at Lloyds Bank.

"The irony here is that in the context of the price action last week, the equity market response could be quite negative and thereby we may actually see U.S. Treasuries supported by safe-haven flows," he said in a note.

Worries of another U.S. recession and concern about the euro zone crisis have already sparked a global stock market slump that wiped $2.5 trillion off company values in the past week.

The fall in global share prices, as measured by the MSCI All-country World Index, was the biggest weekly decline since early October 2008, according to Thomson Reuters Datastream.

Consumer discretionary shares of firms dependent on external demand are likely to be singled out for more punishment.

On Friday, yields on benchmark U.S. ten-year treasury notes were about half a percentage point away from a record lows near two percent hit during the throes of the global financial crisis.

"IRRATIONAL DEPRESSION"

The sharp swings in financial markets have piled pressure on policymakers.

Finance ministers from the Group of Seven most developed economies were due to discuss on Monday the U.S. sovereign rating downgrade and Europe's debt woes, Japanese news agency Kyodo reported on Sunday.

Analysts warned the U.S. downgrade was likely to heighten investors' risk aversion and further bolster the Japanese yen and the Swiss Franc, even though the authorities of both countries took steps last week to staunch the export-denting strength of their currencies.

"Be wary tomorrow of irrational depression as markets take flight," said Justin Urquhart Stewart, a director at Seven Investment Management in London. "We are dealing with the knowns and not the unknowns but what we have a shortage of at the moment is political leadership."

It was not yet clear whether European policymakers would be able to come up with measures to allay such concern, though all the signs were that they were keenly aware of the importance of reassuring markets.

Central bank sources said the European Central Bank would hold a conference call at 1700 GMT to decide whether to buy Italian government bonds in the secondary market.

The ECB last week resumed its purchases of government bonds in the secondary market after an 18-week hiatus but its decision to restrict such purchases to Irish and Portuguese bonds led to sharp declines in Italian and Spanish bond prices.

"There is no reason why the ECB cannot simply go ahead and imply that they are going to support the Italians and the Spanish," said Mike Lenhoff, chief strategist at Brewin Dolphin in London. "It is better that they don't say anything but go in and show there is another side to the market."

Any such ECB buying would offer relief to beaten-down Italian and Spanish bonds.

That would in turn offer a respite to European stock markets. Banks' exposure to Italian sovereign debt and Italian banks have forced equity traders to focus on the rising cost of Italian borrowing and the widening premium that Italian bonds offer over German government bonds, known as Bunds.

Without ECB action, the reverse would be true.

"The fact that Italian 10-year BTP risk premia over Bunds closed near 400 basis points following (Thursday's) ECB press conference, reaching the level of Greece's risk premium before the ECB launched the (bond buying programme) back in May 2010, means that the time to intervene in Italian bond markets is now," said Lena Komileva, head of G10 strategy at Brown Brothers Harriman.

Even so, the extent of any rally in these bonds will depend on how the size and persistence of any ECB bond purchases given investors have been disappointed before by such moves.

Moreover, any ECB bond buying would not address international investors' other major concern at the moment -- the risk of an economic slowdown in the United States.

Goldman Sachs strategists said there was a one-in-three probability of a U.S. recession due to the worsening European crisis, the possible failure to extend payroll tax cuts and elevated levels of joblessness, despite a slight dip in the U.S. unemployment rate in July.

That would bode ill for the benchmark MSCI all-country world stocks index, which last week hit its lowest since September 2010 and has accumulated losses of more than 12 percent since late July.

"Market sentiment appears acutely vulnerable given the build-up of concern on a sharper U.S. slowdown and speculation on the appropriate policy response and lingering fears stemming from the sovereign debt crisis in Europe," Citigroup strategists said in a note.

(Additional reporting by Saikaat Chatterjee in Hong Kong; editing by Swaha Pattanaik)