FOREX TRADING

Market Outlook

Tactical view:

• buy CHF dips vs EUR, GBP

US dollar weakness and Swiss Franc strength translate into an interesting setup heading into the UK Budget, the FOMC and G20 summit next week, and is manifested in USD/G10 crosses approaching potential breakout territory and a rebound in volatility. GBP, NOK, SEK and the CHF all look set to test recent highs as equities negotiate one-month highs Underlying trading themes have not changed and should primarily continue to revolve around sovereign debt risk and the timing of a yuan reval, with US Q2 company results moving onto our radar. We stick to our longer-term bullish USD view but are pragmatic in a context where gold is hitting new highs and deteriorating US macro data and pressure from the G20 to curb public deficits have taken some wind out of the dollar’s sails.

Recap

Gold rose to a new high above $1,260 and platinum also rallied as US dollar weakness returned, but unconfirmed sources report that China was behind the strategic purchases of the precious metals. However, the decoupling with copper is striking and tells us of potential divergence in view over the path for risk assets, also characterised by the sideways price action in major equity benchmarks. GBP experienced a mixed week, gaining ground vs the USD, but posted substantial losses vs the CHF (sharing the pain with the rest of the G10). GBP/CAD rose 0.9% and GBP/JPY firmed 0.7%. The CHF was the star performer after the SNB changed its position on deflationary risks and the strength of the Franc. The CHF gained 3.4% vs the USD, 1.9% vs GBP, and 1.4% vs the EUR.

UK CPI inflation slowed to 3.4% y/y in May from 3.7% y/y in April. RPI inflation eased to 5.1% y/y from 5.3% y/y. The core CPI rate dropped back below 3% to 2.9% y/y. Stronger than expected labour market stats for May reported a fall in total jobless claims back below the 1.5mln threshold, though the employment rate slipped and inactivity rate ticked higher. The RICS reported a bounce in its May house prices index to 22% from 19%, a 4- month high. In his annual Mansion House speech, BoE governor King said that a hike in Bank Rate would precede asset sales. The governor reiterated that inflation should ease back in the months ahead, but shared his concern and said is closely monitoring the rise in inflation expectations.

UK 5y swaps closed near the highs of the week at 2.61% after touching the upper limit of the 4-week range (2.63%). 3-mth Libor held steady at 0.73% for a 2nd successive week, causing the 3mth Libor/5y swaps curve to steepen up to 189bp. The 3mth Libor/Ois spread ended the week flat at 24bp. The 2y/10y swaps curve steepened to 204bp (+10bp), approaching resistance at 206bp. Strong auctions took place for the 2014 gilt (b/c 2.28). The 2017 IL mini-tender was covered 2.53 times. America Movil sold £650mln in 2030 paper (165bp over).

G10 FX – GBP/USD at a Crossroads

GBP/USD has recently been flirting with a return to the 1.4784- 1.55 trading range observed between February and May. An improved technical picture and a rebound in correlations with equities and broader commodities from the early June lows suggest further upside may lie ahead in the short-term (1.54 topside) if the rally in risk asset remains intact and recent gains forces participants to cover short GBP positions. However, the downtrend in place since last November (see chart p2) still dominates and dictates a bearish profile for the medium-term, regardless of the Budget on June 22. A retracement below the 1.45 area cannot be ruled out if the cross fails to break through the 1.4900-50 resistance zone.

GBP/USD has been at a similar crossroads in mid to late April, only for the rally to fizzle out and reverse to the post-election May lows of 1.4231. The danger is that this scenario repeats itself if the rally up to the 1.4886 high on June 18 is not extended beyond trend line resistance situated in the 1.4950 area. The descending trendline in place since January 19 (1.6558 high) runs down to the April 24 high (1.5498). The trendline has not been tested since then and should dampen enthusiasm among those speculating that the cross can drift unchecked to 1.50-1.55, adding to the 1.9% gain in June. Though GBP is currently undervalued vs all its G10 peers (see table), PPP valuations have a very low predictive value when it comes to signalling short-term trend reversals. Speculative short GBP positioning vs the USD is still above historical norms and equally argues for a cautious set-up with tight stops.

The GBP/USD outlook depends on the following:

1/ Commodities, equities: the two asset classes have rallied off the Q2 lows and lifted GBP/USD to a one-month high due to a pickup in correlation (see chart). Short covering, equity buybacks and good EU peripheral auctions (at concessionary rates) may have contributed to a modest buying of risk, but equity benchmarks like the S&P remain 50% below the April high. US Q2 company earnings and guidance for the second half will be key in July for the direction in GBP/USD, provided that correlation with risk remains elevated. Also keep an eye on the CRB index. The index has to test and preferably break the May high (267) to confirm the rally from below 250 and underpin GBP/USD.

2/ Markets have been fairly agnostic to macro economic data recently. Is this about to change? A levelling off in US indicators could bring a second successive disappointing non-farm payrolls report on July 2. This would not go down well with risk assets (USD safe haven) and would add weight to talk that the Fed is discreetly discussing measures to counter a stagnating/ faltering recovery.

3/ Overseas investors have already been reassured that the Con/LD government is determined to cut the public deficit, so the upside for GBP/USD from an endorsement by the credit ratings agencies we think is likely to be minimal. By 2013/14, the OBR projects a reduction in the public deficit from £155bln in 2010/11 to below £100bln, and a fall in public debt from 10.5% in 2010/11 to 5% of GDP. Can the US administration and the USD continue to dodge market fixation with public deficits ahead of the November mid-term elections?

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