FOREX TRADING

Market Outlook:

Tactical view:

• EUR crosses stay offered; counting on stocks for GBP relief
• USD, JPY outperform in risk averse world

The USD continues to attract solid buying interest as confidence in the EUR and GBP wanes. With risk reversals still heavily skewed towards USD calls, the outlook for the dollar index remains uniformly bullish even as the probability of a Fed rate hike this year fades. Economic data has been playing second fiddle in recent weeks and until the picture for risk assets clears up and EU debt fears subside, we think macro data are unlikely to be critical for price action near-term. The high correlation with equities continues to weigh on GBP but with the BoE now also reasserting its influence, we see no immediate escape for GBP from the clutches of the sterling bears. April retail sales and CPI data, and the MPC minutes will keep GBP on a knife-edge next week.

Recap

The positive knee-jerk reaction to a Cons/LD government quickly petered out and saw the market re-establish short GBP positions vs the principal G10 currencies except vs the EUR. GBP/USD dropped below 1.45, and following a dovish BoE QIR, the cross is now slowly gravitating towards the 1.40-1.44 area. Buying of EU peripheral debt by the ECB briefly underpinned the EUR, but selling resumed as the Ascension Day holiday pushed peripheral spreads wider again over bunds. EUR/USD slipped below 1.2500 and now threatens 1.2330, the Oct-08 low. The JPY and USD were the best performers in the G10 as a probe into US sub-prime mortgages and lower commodity prices caused equities to resume their decline, spurring a flight-to-quality. The CAD held up remarkably well considering the fall in crude oil below $75 to a 3-month low, but looks well placed to draw support from the outlook for higher interest rates.

Economic data continues to be a sideshow to the jitters in equity and sovereign debt space. The BoE kept Bank rate unchanged at 0.50% and the APF at £200bln, but in its quarterly Inflation Report it warned of downside risks to growth as public spending cuts in the EU and the UK threaten to hit demand. The BoE also sees CPI below 2% target in two years time based on the implied futures curve for interest rates. Manufacturing production rose a much stronger than forecast 2.3% m/m in March, fuelling speculation of an upward revision to Q1 GDP later this month. Jobless claims fell in March by 27,100, and the ILO unemployment rate held steady at 8%.

UK 5y swaps slumped from a 2.94% high on Monday to 2.66% on Friday, causing the 3mth libor/5y swap spread to narrow below 200bp. A similar drop in gilt yields kept swap spreads within recent ranges. EU and US yield curves also flattened, with good demand at benchmark auctions and risk aversion driving the compression in long dated yields. Libor/OIS spreads widened in the US, the UK and the EU.

Market Outlook

Tactical view:

• EUR crosses stay offered; counting on stocks for GBP relief
• USD, JPY outperform in risk averse world

The USD continues to attract solid buying interest as confidence in the EUR and GBP wanes. With risk reversals still heavily skewed towards USD calls, the outlook for the dollar index remains uniformly bullish even as the probability of a Fed rate hike this year fades. Economic data has been playing second fiddle in recent weeks and until the picture for risk assets clears up and EU debt fears subside, we think macro data are unlikely to be critical for price action near-term. The high correlation with equities continues to weigh on GBP but with the BoE now also reasserting its influence, we see no immediate escape for GBP from the clutches of the sterling bears. April retail sales and CPI data, and the MPC minutes will keep GBP on a knife-edge next week.

USD

The USD continues to attract solid buying interest as confidence in the EUR and GBP wanes. Confidence in the EUR was only briefly restored after the EU’s 750bln eur stabilisation mechanism and ECB buying of EU peripheral bonds. The rally in GBP after the announcement of a Cons/LD coalition equally proved short-lived. With risk reversals still heavily skewed towards USD calls, the outlook for the dollar index remains uniformly bullish even as the probability of a Fed rate hike this year fades.

The dollar index raced through 85.0 and 86.0 levels with remarkable ease on safe-haven flows, but strong overseas interest at the US quarterly refunding also added demand. This supports our medium-term view for a rally up to the Mar-09 high (89.60). Key resistance is situated at 86.76.

It did not take long for sellers of EUR rallies to step in and pile pressure on EUR/USD for a test of 1.25. Record IMM short EUR positioning highlights the market’s bias and after option levels were erased in the 1.2500-50 area, the pair slipped to a low of 1.24 33 low. Key support now runs at 1.2330, the Oct-08 low. A break clears the path for 1.20.

The week ahead features PPI, CPI and the FOMC minutes. Economic data has been playing second fiddle in recent weeks and until the picture surrounding the probe into US sub-prime mortgages and EU debt clears up, macro data is unlikely to be critical near-term. US core CPI has continued to tick lower since the start of the year, hitting 1% in March. A strong dollar and lower oil prices should help to bear down on consumer prices in the near term, warranting the Fed’s relaxed stance in interest rates.

Fed commentary could be instructive with regard to the likelihood of asset disposals. How the committee views dollar strength from a monetary policy perspective is unclear. The decision by the Fed to re-activate USD swap lines with other central banks was only decided last week and will not feature in the minutes. TIC flows, housing starts and building permits are also due, and will give a first glimpse of residential construction at the start of Q2.

EUR

What was initially received as a silver bullet has failed to put doubts to rest over a possible debt restructuring and haircuts for financial institutions holding Greek, Portugese and Spanish debt. New fiscal austerity packages were agreed this week in Portugal and Spain, and provided a temporary fillip to equities and the single currency. However, as soon as the ECB disappeared as buyer of peripheral benchmark bonds, spreads immediately shot up vs bunds, lead by a 66bp surge in Greek 10 yields. This is indicative of the bearish sentiment that continues to stalk the single currency, with rumours of further sovereign downgrades to boot.

Sentiment remains overwhelmingly bearish vis-a-vis the EUR. With speculative EUR positions at a record high, buying below 1.25 in EUR/USD is likely to be sporadic. We reiterate our preferred tactic of selling EUR/USD rallies. Failure to bounce off 1.2330 support argues for a retracement to 1.20. EUR/USD risk reversals bounced off -3.195 low to -2.54, pointing to a less bearish skew.

For EUR/GBP, a post UK election bounce lifted the pair to 0.8620 high, before profit taking set in. The dovish BoE QIR has not done GBP any favours vs other currencies in the G10, but the line of least resistance from a EUR perspective is for a decline back to 0.85, with a test of 0.8422 impossible to rule out over the coming week. In contrast to the widening tendency for Spanish and Italian yield spreads over bunds, 10y gilts have managed to hold up around 90bp pivot, and 2y gilt/bunds finding support at 38bp.

The focus next week is on targeted ECB bond purchases, the Ecofin meeting and the maturing ofGreek 10y debt. Leading indicators of activity have so far held up remarkably well in the face of pledges to cut public sector wages and abolish various tax credit schemes. The release of the May PMIs next Friday will attract close scrutiny for confirmation that confidence in services and manufacturing sectors is not dented by the sovereign debt jitters.

GBP

The high correlation with equities weighs but with the BoE now also reasserting its influence, we see no immediate escape for GBP from the clutches of the sterling bears. In the end, knee jerk buying of GBP/G10 on PM Brown’s resignation almost surpassed the reaction to PM Cameron’s nomination. Though the initial noise surrounding budget deficit reduction plans by the Con/LD government is promising from a ratings perspective, GBP has not escaped the widespread selling vs the USD and JPY. As we await the emergency Budget in 50 days time, hopes for a near-term bounce in GBP/USD and GBP/JPY are pinned on a bounce in commodities and stocks. Failure of the FTSE to regain 5,500 does not bode well for the ST.

April CPI data and the MPC minutes will keep GBP on a knife-edge next week. Even if CPI surprises to the upside (cons f/cast 3.5% vs 3.4% in March), selling of GBP/USD rallies is preferred. The BoE QIR made clear that downside growth risks have returned and that inflation remains on target to fall below 2% target in two years. The idea that the BoE may extend asset purchases later this year has been touted in some quarters. With the Fed moving in the opposite direction and voices on the FOMC mulling asset sales, the danger exists for a fall in GBP/USD to 1.40 in the weeks ahead, backed by a narrowing in US/UK 10y rate differentials.

Along with GBP, the AUD is equally highly correlated with stocks and this explains the sideways price action in GBP/AUD between 1.62 and 1.65. The situation is different for GBP/CAD, where the unchanged prospect of a hike in Canadian interest rates this summer could magnify the selling pressure in GBP/CAD below 1.50 over the coming weeks, with the 1.4581 low of February 1985 an obvious target.

GBP and JPY are situated at opposite sides of the scale vs risk assets. Bearing in mind the bearish set-up in stocks, GBP/JPY bulls are far and few between. After taking out 135.0 support, focus will shift to the May 6 low of 130.08, though interim support rests at 1.3203. The lower end of the trend channel dating back to June last year runs at 128.0. Resistance is situated at 140.0.

Aside from CPI, next week also features the May MPC minutes, April retail sales (cons f/cast +0.2% m/m), Q1 business investment (f/cast -0.6%) and public finances for April (PSNB f/cast £7.0bln).

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