Today our theme of risk appetite hit a speed bump as we had some weak fundamentals from the UK and US that will surely bring back the chorus of those that see a double-dip global recession on the horizon. While growth is strong in the developing world – China comes to mind – the developed nations are seeing some worrisome signs heading into the second half of 2010.

A Summary of The Global Economy Heading into the End of 2Q 2010

In the Euro-zone, while Germany is being powered by exports, the sovereign debt crisis and the tightness it has created in bank lending will be a drag on the economy. It is why the ECB has stepped in and bought 45B euros worth of bonds as money markets began to act “dysfunctional.” The whole sovereign debt episode will weigh on European consumer who will be more nervous to spend. But the main thing that may keep down growth will be the austerity measures that the southern rim of Euro-zone countries will have to undertake which will cut into economic activity. Germany which is trying to get ahead of their own fiscal situation will also be taking an ax to its budget in order to lower its budget deficits.

That’s a theme coming from the UK as well as the new PM has made it clear that the UK will undertake dramatic cuts that “will affect every person in the country.” The recovery is weak so far and first quarter growth came in at 0.4%. The BOE will continue to provide loose monetary policy, but if inflation continues to be high, they will have to raise rates sooner or later. The country’s CPI is running at 3.7% in annual terms, a figure that is way above target, though the BOE assures the country that the high level will be temporary.

In the US, there was some hyped expectations that the recovery was gathering momentum as manufacturing readings came in strong, the labor market looked to be turning a corner, and the housing sector took advantage of an expiring tax credit to sell a strong amount of homes. However, all three may see strong headwinds. Government stimulus is running out and that may cool manufacturing activity. Also companies have probably finished restocked inventories. Labor market figures have been rather disappointing of late. The NFP report showed a very weak 41K of new private sector jobs created in May, following gains of 158K in March and 218K in April. Finally, weekly jobless claims, which had been in a downtrend throughout 2009, have been stuck in a sideways range, unable to move below the 450K level.

The economic growth, as admitted by Bernanke, will mean that the unemployment rate will come down slowly. Add to that the inevitable slump in housing sales following the end of the expiration and the impact on the regional economy of the Gulf Coast due to the Deepwater Horizon oil spill and we can see the earlier optimism about the economy dissipating. Also, the US had hoped to fuel growth by increasing exports, but with the Dollar strengthening in the wake of the Euro-zone debt crisis, those gains will be hard to come by.

Countries tied to global growth and commodities like Canada, and New Zealand have joined Australia in raising interest rates. Australia is being powered by its mining sector which is feeding the hungry demand of China and other Asian nations. Canada’s economy is more based on domestic demand, but recent export figures have been very soft as US consumers reign in their spending. Still, job growth has been rather strong in these economies and we will have to see how the recent turmoil in financial markets filters down into global trade.

The Australian economy added 27K jobs in May, beating expectations and the unemployment rate fell to 5.2% from 5.4%, almost half the levels we see in the US and Europe

Here’s a chart of employment change for Australia and we see that the economy has seen job growth 8 out of the last 9 months. The unemployment rate (the blue line) is inverted on this chart, but it peaked back in September.

That’s the overall situation as we move through the last month of the second quarter. Coming into this week we had risk aversion in currency markets following the weak NFP data from the US and a flare up of the sovereign debt crisis in the Euro-zone because of Hungary’s troubles.

This Week’s Risk Appetite Fueled by Bernanke’s Cautious Optimism and Strong Data from Asia/Australia

Early in the week and over the weekend Hungary walked back its statements, calming that fear. Fed Chairman Bernanke while in Asia gave cautiously optimistic comments about the US economy, saying that while government stimulus will fade, consumer spending and business investment will sustain the economic recovery. In other words, there should not be a double dip recession in the US. Adding in a leaked report that Chinese exports (and imports) were very strong in May, it helped to calm the main fears in markets – the sovereign debt in the Euro-zone, that the US economy will stall and turn negative, and that global trade will retrench because of Europe.

That gave us the conditions of risk appetite and we saw some strong gains from our “risk-on” trades. The Euro and Pound rallied against the Dollar and Yen, and the commodity bloc of currencies like the Australian and Canadian Dollars surged as well. Part of the gains was a paring of the sharp losses seen in riskier assets to end the previous week and equities coming off some low levels.

For example, here’s our look EUR/USD:

And the AUD/USD:

Besides the Chinese trade data, there wasn’t that much fundamentals to go on. Australia saw another strong month of job growth, Japan’s GDP for the 1^st quarter was revised higher, and US jobless claims declined for a second straight week. But overall, equities led the way.

Friday’s Risk-Rally Speed Bump

That brings us to today. We had two important releases. First, in the UK we saw industrial production slide sharply in the month of April. Expectations were for a 0.4% increase, instead we got a 0.4% decline. That adds evidence that the UK recovery is a weak one, as the output in production was one of the factors showing strength recently in the economy.

The GBP/USD pair responded by shedding one-half of this week’s rally.

Second, we had US retail sales slide a sharp 1.1% in the month of May, the first decline since last September. Expectations were for a small gain. That confirms that US consumers have been affected by the negative stories coming out of Europe, the Gulf Coast, while they remain uncertain about the pace of improvement in the labor market. Consumer spending will be a very important factor to seeing if the recovery will be sustainable and the May figures are very disappointing. The preliminary reading of the UMich consumer sentiment for June posted a 75.5, up 1.9 points from May’s 73.6. US stocks which opened lower made up some of their initial losses in very early NY trading.

The weak news from the UK affected markets more than the sour US retail sales as weak data from the US actually benefits the US Dollar as a safe-haven, or when risk trades are switched from “on” to “off.”

What to Expect Going Forward

Now, the US sales data is nothing like the jitters that hit markets when we hear about problems with banks in the Euro-zone like we saw in Hungary. So far, the reaction has been a pause and consolidation, profit-taking heading into the weekend.

Where do we go from here? How investor sentiment shapes up following the weekend of course will be key. Will the weak data to end the week – from the UK and US – dent risk appetite? Was this week’s rally in risk a bounce from the sell-off seen the previous week? These are the questions facing the currency market.

Fundamental data will be relatively quiet to start next week. The fundamental docket picks up on Tuesday when we get data on German economic sentiment for June and on Wednesday when we get reports on the US manufacturing sector. Wednesday will also bring UK employment data as well as inflation data from the US. Thursday, eyes will turn to the Swiss National Bank as it concludes its quarterly interest rate meeting and explains what it plans to do regarding the appreciation of the Swiss Franc.