Market Outlook

Tactical view:

• EUR/GBP: return to June low?

Comments by ECB council member and 2011 candidate president Weber on the possible extension of unlimited liquidity until year-end have not gone unnoticed, casting a shadow of the ST outlook for the EUR. In a market short of liquidity and marked by a retreat of risk, Weber’s comments may hasten the decline in EUR/USD from the August highs. With risk beating a retreat, the success of Japanese officials to temper the decline in USD/JPY can be questioned and indicates that the cross may be settling in a range around 85.0. The perceptible weakening of the US economy in Q2 is showing signs of spilling over in Q3 and means the USD is set to remain a safe haven magnet along with the CHF. Unrevised UK Q2 GDP data next week may add fuel for a return in EUR/GBP to the June lows.

Recap

UK macro data continued to impress but ran into aversion for risk, resulting in a mixed performance for GBP vs other G10 currencies. GBP/USD fell 0.4% to 1.5532, having slipped below 1.55 for the first time since July 27. GBP/EUR ended the week virtually flat at 1.2226, but potential for a move to the upside appears to be building. EUR/USD dropped 0.4% and USD/JPY stalled above 85.50, logging a drop of 0.65%. A test of the Nov-09 low still looms, though reluctance to push the cross lower on a sell-off in stocks indicates that investors have become more wary of intervention ahead of the next BoJ meeting. The CHF topped the G10 table with solid gains vs the USD and EUR.

Early indications show that momentum from UK Q2 GDP is carried over into Q3 at least on the consumer spending side. Retail sales rose a stronger than forecast 0.9% m/m in July, posting a third successive gain. June data were revised upwards. This will dampen speculation of the MPC soon resuming its asset purchase programme. The MPC minutes showed the committee voted 8-1 in August to keep BR and the APF on hold. Discussions included both an easing and modest tightening in policy. ECB member Weber stated his preference to extend unlimited liquidity until year-end. US economic data continued to disappoint. Reports of a jump in weekly claims to 500k and a fall in the Philly Fed survey to -7.7 mean additional Fed measures and stimulus spending cannot be ruled out.

No change in theme. Bullish seasonals and weak US macro data helped gilts to extend their stellar performance, with 10y gilt yields dropping below 3% and EU 30y yields falling below 3%. For 10y gilts, the 2.93% low of 2009 is now within striking distance. Even as investors question bond valuations, there could be further downside for yields and swaps if UK data sours. 5y swaps dropped to 2.07%. The 2y/10y swap spread tightened to 182bp, with cash compressing to 234bp. The 10y swap spread held at +5.

G10 Strategy: EUR/GBP – Return to June Lows?

Comments by ECB council member Weber on the possible extension of unlimited liquidity until year-end have not gone unnoticed, casting a shadow of the ST outlook for the EUR and EU sovereign spreads. EUR/GBP has been gradually losing ground since hitting a 0.8532 high on July 20. But with a bounce from 0.8175 high failing to catch on and follow though buying not materialising, we wonder if the cross is revving up for a potential breakout to the downside. A successful move below 0.8175 would favour a return to the late June lows situated below 0.81. Here is an overview of the factors that could drive price action over the coming weeks.

ECB member Weber has stated his preference to extend unlimited liquidity operations until year-end, and added that discussions on exit strategies would be focused on Q1-11. This implies that the ECB may accept an extension of the existing weekly, 1mth and 3mth facilities at the September meeting, irrespective of an upgrade to the outlook for 2010 EU GDP > EUR negative

Though the MPC voted 8-1 and considered both an easing and a tightening in policy in August, incoming data continues to defy pessimistic projections for the second half. With momentum in retail spending carried over from Q2 into early Q3, the case for unchanged BoE policy remains intact > GBP positive

GBP speculative positioning vs the USD has flipped from negative to positive in August, resulting in a widening of short EUR vs GBP contracts to the highest level since Jun 29 (now long GBP vs EUR). Though bearish EU sentiment has also faded, net overall positions have remained short vs the USD > GBP positive

EUR/USD correlation with risk assets spiked this week to 0.91, the highest since May. The transmission of weaker stocks to EU peripheral bond spreads (wider over bunds; Greece 850bp, Spain 180bp) infers that EUR/USD may have returned to a new phase of underperformance vs GBP/USD, though it must be said that the latter remains highly correlated with the CRB index (0.89). In other words, EUR/GBP is primed to move in line with stocks > EUR subject to greater downside danger from lower equities

UK/EU 2y benchmark rate differential has flatlined in a tight trading range close to the zero boundary since mid July, occasionally flirting with negative territory. The narrow range resembles the period around early March, but is below the 20bp mean observed since January. Unless UK macro data start to deteriorate, a further compression in the UK/EU spread into negative territory is unlikely. Separately, the Mar-11 GBP vs EUR strip has stabilised at 15bp. This marks a return to the upper end of the 6-week range.

The comments by ECB member Weber, candidate to take over as president from Mr Trichet next year were uncharacteristic for one of the most outspoken hawks on the governing council. The nature and timing of the comments in thin summer markets and during ECB recess may have been ill-judged and within hindsight may prove counterproductive for the region’s weakest sovereign debt markets ahead of next month’s supply glut. However, the impact of his statement on the extension of liquidity operations should not be overstated as a driver for EUR flows against a backdrop where the glow of upbeat Q2 corporate earnings has been replaced by a reversion to safety following alarming updates for US weekly claims and the Philly Fed survey.

Full Report in PDF