FX Strategy Weekly
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Market Outlook
Tactical view:
- Risk of snap back in GBP/USD and USD/JPY
- Long AUD positions outpace CAD
Dollar weakness continues to characterise G10 fx markets as doubts over the US economy multiply and all-time lows for US yields boost the attractiveness of carry. With the Fed running out of policy options and evidence of macro economic decoupling in the G10 prevailing, we look for the AUD to remain a desirable G10 destination. A test of 85.0 in USD/JPY now looks probable. Though next week will be dominated by the FOMC, all eyes in the UK will be on the latest BoE Inflation Report (QIR) on Wednesday. The QIR has proved a hurdle for GBP in the past and could again prove the proverbial ‘bridge too far’ that forces GBP/USD bulls to rein in their exuberance. Special notes on GBP/USD and AUD/ ZAR are included in this week’s publication.
Recap
GBP/USD closed up 1.7% at 1.5962 and just fell short of 1.60. GBP lost 0.04% vs the EUR as EUR/USD (+1.7%) kept track of GBP/USD. GBP/CAD burst through the 1.64 level (1.65 target) after a shock 139,000 drop in Canadian employment in July. The MPC left Bank Rate on hold at 0.50% and the APF at £200bln, but suspense is set to stay elevated over the next two weeks and leaves GBP vulnerable to possible profit taking after a stellar run. Elsewhere, we note the gains for the JPY and the fall in USD/JPY blow 0.8550. A test of the Nov-09 low now looms, prompting possible intervention to weaken the yen.
US payrolls dropped 131,000 in July, double the consensus estimate. Data for June was revised down to -221,000 from -125,000. The unemployment rate held unchanged at 9.5%. UK data highlights were the 4.3pt drop in the construction PMI in July, and smaller falls in the manufacturing (-0.2pts) and services (-1.3pts) PMIs. The three PMIs have now declined simultaneously for two consecutive months, pointing to a slower rate of expansion in Q3. The NIESR reported a rise in GDP of 0.9% in the three months to July vs 1.1% in June. The ECB left its interest rate on hold at 1.0% but reined in optimism over the economy and declared no recovery victory. Strong Q2 GDP data are expected from Germany next week.
Backed by bullish seasonals and weaker macro data, gilts logged an impressive week with yields dropping markedly across the curve, but with the long end outperforming. 10y yields descended below 3.25% to a 3.23% close. Support for a further decline towards 3% could be on the cards. 5y swaps dropped 7bp to 2.35% and the 10y closed 11bp down at 3.27%, causing the 2y/10y spread to flatten below 190bp. The 2y/10y gilts spread tightened below 250bp and closed the week at 245bp. The 3mth Libor/Ois spread held steady at 25bp. The 10y swap spread was also unchanged at 5bp. The 5y gilt auction drew solid demand and was covered 1.99 times (0.7bp tail).
G10 FX – GBP/USD: Negate QIR?
We have argued the case for a rally in GBP/USD since early July, but following a stellar run from below 1.48 on 1 July to above 1.59 in early August, we wonder if upside has now been exhausted and a correction back to 1.55 looms.
Though next week will be primarily dominated by the FOMC decision on Tuesday and whether or not new tools are considered to prod the US recovery, all eyes in the UK will be on the latest BoE Inflation Report (QIR) on Wednesday August 11. The QIR has proved a hurdle for GBP in the past and could again prove the proverbial ‘bridge too far’ that forces GBP/USD bulls to rein in their exuberance. However, the latest jump in correlation of GBP/USD with risk assets suggests that a test of 1.60 remains achievable until aversion for equities and commodities returns. The initially tame reaction by risk to the weak US August employment data indicates that demand for carry is still intact from which GBP/USD should indirectly benefit.
One could argue that the immediate concern from a GBP perspective should theoretically be the BoE Inflation Report (Aug 11) and the MPC Minutes (Aug 18). However, a 0.8/0.9 correlation of GBP/USD with equities and commodities (see chart 2) argues to the contrary. Inflation Reports have since the start of the recession occasionally resulted in sharp swing for GBP/USD (see chart 1), but this time the deterioration in US fundamentals and remarkable, though questionable muted response in commodities and stocks could mitigate the bearish influences from the QIR.
The QIR will be important to understand i/ what the MPC makes of the growth and inflation projections for the next two years based on public spending cuts and VAT hike presented in the Budget and ii/ if lone hawk Sentance still voted for an immediate rate hike. Bank governor King last week emphasised that downside risks to growth still do prevail and that therefore ‘putting the foot on the brakes’ would be a policy mistake. If considering the right amount of stimulus is currently at the heart of the policy discussions, then this implies that additional QE could still be discussed (UK 10y yields heading for 3%?). One could therefore argue that the QIR could be a GBP negative event as the rear view mirror image of a stronger economy is negated by the uncertainty ahead as public spending cuts start to bite and the pace of credit easing slows. Back in May, the BoE forecast GDP growth of 1.2% this year and 2.3% in 2011. CPI inflation is forecast to average 1.7% this year and stay below target in 2011 based on implied market interest rates.
The retreat of the USD vs G10 currencies is a factor and cannot be overlooked as worries grow that the Fed is effectively running out of ammunition to spur the economic recovery. Though doing nothing is not politically palatable ahead of the midterm elections, the impact on the economy from rolling over the proceeds of $200bln worth of MBS securities, an idea discussed in the WSJ this week, is highly debateable. Having cut interest rates to 0.25% and purchased securities in excess of $1.0trln, one wonders what an extra $200bln or reduced interest rate on commercial bank reserves will achieve in a world where 30y and 15y mortgages rates have already reached a record low. Fed fund futures have now pushed forward the timing of a first rate hike past Nov-11. This is the ‘new normal’.
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[...] GBP/USD closed up 1.7% at 1.5962 and just fell short of 1.60. GBP lost 0.04% vs the EUR as EUR/USD (+1.7%) kept track of GBP/USD. GBP/CAD burst through the 1.64 level (1.65 target) after a shock 139000 drop in Canadian employment in … View full post on GBP/USD – Google Blog Search [...]