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The last couple of trading sessions have been dominated by monetary policy meetings. The US Federal (Reserve) Open Market Committee (FOMC) was the highlight of yesterday, with the first of the post-announcement press conferences from Chairman Bernanke.

In summary, the statement was largely unchanged from the previous meeting. The well-oiled phraseology of “rates to remain exceptionally low for an extended period” was kept and, despite a couple of minor changes to the wording surrounding the short-term (albeit transitory) inflationary pressures and “moderate pace” of the recovery, the message remained one of ‘wait and see’. Bernanke clearly stated that the Fed plans to buy all $600 bn (QE2) through June and continue reinvesting maturing debt. In fact, in the press conference Bernanke suggested that “ending reinvestment would mean tightening”. 

The FOMC policy makers revised down the growth for this year as a result of what they see as temporary weakness in Q1 (pertinent for the fact that the first estimate of Q1 GDP is released this afternoon) and revised up slightly the inflation outlook. However, with underlying price pressures still subdued and the admission that “extended period” means a couple of meetings in the mind of the Chairman, the USD is likely to remain the funding currency of choice. Further USD selling capitulation overnight is confirmation of this view from the market ahead of the long weekend (at least in the UK). 

The USD’s inherent weakness is likely to continue in the near term, at least until the Fed begins to signal an end to the increasing accommodation or inflation pressures put upward pressure on interest rate expectations. With the inaugural press conference successfully underway, I would anticipate that the next scheduled press conference on 22 June is the most likely arena for a subtle shift in language and the communication of a gradual move towards monetary normalisation.

Overnight we have also had a monetary policy decision from New Zealand, where rates were left unchanged at 2.50%. RBNZ Governor Bollard signalled that rates are likely appropriate for some time as consumer confidence slowly recovers from the earthquake and inflation remains comfortably within the band at the forecast horizon.

Finally, the Bank of Japan also held rates steady overnight at 0.10%, maintaining the credit loans, asset purchases and government bond purchase targets all unchanged. The one caveat here, however, is that the overnight data was much weaker than the market had been expecting in terms of household spending and industrial production, and the likelihood of further stimulatory measures is increasing. Further moves towards debt monetization will soon become a negative for JPY as downside risks to the economy prevail in the short term. This will give a very strong opportunity to sell JPY, as it is likely to retake the title of ‘funding currency of choice’ as Q2 progresses.

Have a great weekend

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The UK has been the big focus of the day so far as the first of this weeks big events, the Q1 UK GDP release, has highlighted the conflict between valuation and expected growth trajectory (or the economic differentiation - that we have oft mooted here) arguments to a head.

Ironically the growth figures for the first three months of this year came in exactly in line with the average projected economist forecasts for the data.  However recent sentiment towards GBP has deteriorated following a lower than expected inflation reading for March, emerging political concerns and – most importantly – a growing fear that the governments austerity measures will kill off consumer activity as we move towards the summer months and beyond.  This had lead a fearful market to ‘expect’ a lower than expected number!

On the UK growth trajectory however, I would beg to differ.  There is evidence from the recent retail sales data in the UK that the disappointing consumer activity that was experienced in the March survey and retail data, was as much a function of the timing of the Easter holiday period on a year on year basis as a fundamental constraint to expenditure.  On that basis I see the trajectory of consumption currently at a much higher level than the doomsayers.  The breakdown also showed that despite a very disappointing construction sector, the dominant sector of the UK economy (Services at 76% GDP) rose by 0.9% q/q – the fastest rate of growth in four years.

Admittedly the UK economy is facing difficult times and we are far from out of the woods – Growth is now only back to the same level it was in Q3’10 - however, from a relative value perspective GBP is still cheap and if you combine this with the view that the growth trajectory of the UK is not as perilous as is commonly viewed then the economic differentiation argument also holds value for GBP at current levels.

The second of the days events will come after the UK close as Federal Reserve Chairman Ben Bernanke gives his first press conference following the monetary policy meeting.  It is very unlikely that the inaugural press conference will be the forum for any announcement of policy or even nuance change.  Bernanke is likely to maintain the “rates to stay exceptionally low for an extended period” language, highlighting the disappointing improvements in unemployment and the continued low level of core inflation in the US.  The FOMC central tendency projections will be closely watched as the much debated growth trajectory of the US comes back into focus ahead of the important US Q1 GDP release tomorrow.  Despite the reiteration of a ‘strong USD policy from Treasury secretary Geithner yesterday the USD remains on the back foot – with the USD having been in broad decline for the past decade with a strong USD policy, this statement has clearly lost its impetus.

Liquidity is still fairly low in the current short week and with another four day weekend in the UK ahead, positions are liable to being unwound as we move towards tomorrows US data, but for now further extensions are likely.

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The long hot weekend brought with it limited action from financial markets in the centres that were open for business.  The USD remains on the back foot highlighted by the Fed’s official release that the USD trade weighted index fell to the lowest on record on April 21st at 69.0337 and despite a brief position adjustment over the past 24 hours, that trend is likely to continue.

This week there are a couple of events that will drive broader economic sentiment and likely the near term dynamic for financial markets, particularly foreign exchange.  The first being the UK Q1’11 GDP release and the second being the US FOMC meeting, both on Wednesday.  In addition to this we will also get Q1’11 GDP from the US to close the exceptionally short week in the UK.

In the UK, interest rate hawk Martin Weale’s comments on Friday that Q1 GDP may be weaker than expected, played into the hands of those economists who had significantly revised expectations for the release down after the OBR construction data for the period.  Economists’ forecasts for the release now sit at around 0.5% q/q with sentiment probably skewed to the downside.  However, despite the potential for a weak number (Martin Weale expressed a view that he wouldn’t be surprised to see Q1 GDP below 0.7%q/q) and despite the much publicised and anticipated impact on the fiscal austerity drag on consumer spending as the year progresses, we see the trend average of Q4’10 and Q1’11 (to take account for the December weather distortions) to be the low point in the trend and the timing of Easter which suppressed activity in Q1, to lead to a greater degree of consumer momentum than is currently priced into expectations going forward.  In that regard, whilst there may be some increased volatility over coming session, GBP continues to offer value.

In the US, the FOMC meeting on Wednesday will be a historic event.  Not because there is likely any change to policy but because there is an important change to the modus operandi for Fed communication.  On Wednesday, Chairman Bernanke will give his first post-meeting press conference and the Federal Open Market Committee (FOMC) will release its ‘central tendency’ economic forecasts at the same time.  These ‘new’ press conferences are now scheduled to take place after each of the 2 day fed policy meetings (which account for 4 per year).  With the recent softness in the US economic data we would expect the forecasts to highlight caution in the Q1 (and potentially beyond) data and with unemployment still stubbornly high and limited inflationary pressure we would anticipate Chairman Bernanke to retain a dovish overall tone and is unlikely to shift emphasis away from a full completion of QE2 in June – and not earlier.

This week may be short but it is likely very a very important steer on monetary policy and economic trajectory in the UK and US.

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The eurozone periphery woes continue unnerve bond investors as we approach the long weekend and continuing speculation of a Greek restructure – though vehemently denied and rejected by Greek and eurozone officials – is pushing Greek (and Portuguese) debt yields, and CDS to record wides.  The 5 year Greek Credit Default Swap is now pricing in an implied 67% chance of a default within 5 years.

One very important development in the markets that has been further highlighted this week, much to the chagrin, of many fundamental economic commentators and forecasters, has been the ability of the FX market to shrug off the PIG (Portugal, Ireland and Greece) sovereign concerns and continue to back a stronger EUR.

The main argument here and one that this page has oft mooted and concluded is that whilst the concerns are limited to the PIG countries and contagion has been contained to those three then the broader issues of a rising interest rate term structure differential between the eurozone and the US, along side growing concerns over the USD (despite the significant volatility that we have seen this week), the EUR will continue to benefit.  Spain is the important barometer of sentiment in this regard.

Our views on the USD are well published yet it was the strong demand at the Spanish auction yesterday that has seen a growing differential between the yield demanded by investors to hold PIG paper (particularly Greek and Portuguese) and that demanded to hold Spanish paper that has driven the EUR and in the short term will continue to be a dominant driver.

In a broader economic context the global backdrop has shifted firmly back towards ‘risk on’ as the Q2 earnings season in the US gets underway and outperformance of US giants such as Apple and GS have fostered a strong bounce back in equities globally.  Overnight this market ‘positivity’ was apparent in a marked appreciation of Asian currencies (notably Korean Won and Singapore Dollar).  This appreciation was enough to spark significant central bank intervention in the currency markets to buy USD and sell local currency.  The knock on effect of that in the major FX space is that in order to retain foreign exchange reserve portfolio diversification, they need to sell some of the USD purchased for EUR’s.  This has been apparent this morning.

In the UK the retail sales data surprised to the topside and whilst the higher March data show no real signs of a pick up in discretionary spending and will likely point to only 0.3% growth in Q1, the data are adjusted for Easter and would therefore suggest that some of the weaker consumer data that we have had in the UK of late have been understated due to the timing of Easter.  Therefore the consumer momentum at the start of Q2, will likely be more positive than has been feared in recent weeks.

On a final note of positivity into the weekend the UK public sector finance data released this morning showed that the budget deficit for the fiscal year 2010/11 came in around £5B less than the most recent OBR forecasts.  In fact if you add in the contribution from public sector banks the improvement is around £12B.  The UK’s fiscal responsibility has been variously criticised over recent months but improvements in the deficits will bear considerable fruit in the medium to long term.

Have a great long weekend

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The Bank of England’s Monetary Policy Committee meeting minutes, released this morning, confirmed what the market had been expecting since the lower than expected CPI print for March – That Rates are likely on hold in May - although due to the fact that May is a quarterly inflation report month it is not inconceivable that the new forecasts alter the balance of risks enough to tempt two members into the Hawks camp, which would be enough to signal the start of the rate normalisation process.

The minutes conveyed a relatively dovish tone and once more highlighted the “sizeable opposing risks on the outlook for inflation”.  The hawks, lead by Andrew Sentance, who once again voted for a 50bp hike to the Bank rate (along with Spencer Dale and Martin Weale, voting for a more moderate 25bp hike) failed to persuade any of the ‘wait and see’ camp to leave the middle ground.  Whilst Adam Posen continues to express his preference for an increase to the Asset Purchase Target (or further QE), his position is becoming more and more disjointed from a general acceptance that the significant monetary accommodation in the UK will have to be removed before too long.

The committee also expressed a concern that a rise in the Bank rate at this juncture may adversely impact consumer confidence and spending.  In this regard the retail sales figures for March, released tomorrow, will be important in gauging the momentum in domestic demand moving into Q2 after disappointing (albeit volatile due to weather effects) Q4 ’10 and Q1 ’11 economic growth figures.  In fact the committee stated that it was as yet “too early to say if the Q4 slowdown was temporary.”

The initial impact of the release of the minutes was a moderate negative for GBP and for UK rate expectations, but despite the slight dovish tone, we still expect the rate normalisation process to begin this year, now most likely in August.  As discussed above this was also the central view of the market prior to the minutes and the reaction to the release was therefore very mild.

Elsewhere our concerns over the US and USD continue and after a very volatile position unwind at the start of the week the USD has once again lost its shine.  In Europe this was aided this morning by strong demand at the Spanish bond auction, despite rising borrowing costs (amid expectations that Greece may restructure its debt.).  The strong demand is further evidence that the battleground for the containment of sovereign debt contagion is being hard fought in Spain.  Continued support from China and the commitment from IMF and World bank that Spain (whilst it has its problems) is in a much stronger position than the wider European periphery (and as such will not need a bailout) adds further to the eurozone arsenal.

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Yesterday’s price action in financial markets was dominated in the early session by position unwinding and continued concern over periphery sovereign debt concerns in the eurozone – predominantly the question mark over the sustainability of the Greek fiscal situation and the growing concern over the possibility of a restructuring of Greek debt.

In the afternoon session a new twist to the global sovereign debt story was added by rating agency S&P, who downgraded the outlook for the US long term debt rating (whilst affirming the AAA rating) to a negative outlook.  In FX the reaction was initially to cause a sharp fall in the USD yet as the move developed into a market that was in ‘position unwinding mode’ (which was dominated by USD buying) and the resultant volatility saw the USD index breaking the recent downtrend and the hot money which had sold USD (particularly vs. EUR and GBP) being unwound into an increasingly volatile market.

After stepping back from the market gyrations during the day and after the short term positioning had been largely unwound, the overnight moves were fairly orderly.  In our view the bigger picture has still not changed. 

The downgrade of the US outlook by the credit rating agency is perhaps more of a warning shot across the bows of the US policy makers that the Budget squabbles have seriousness beyond the partisan political disagreements.  The fiscal situation in the US is a very serious matter and in our view the most probable outcome from the events of the day is that US rates stay lower for longer.

In the near term however there is a rationale behind maintaining a ‘backfooted’ stance in order to be able to benefit from any resumption of that position unwinding into the long Easter weekend.  The volatility that was demonstrated yesterday will likely keep the markets attention focussed on the potential for a near term USD reversal and sensitivity to the eurozone periphery remains high into the long market holiday.

In the UK tomorrow’s data will be key as we will be fully furnished with the public sector finance data and how the deficit for the past fiscal year compared to the budget and OBR forecasts – This will be very important as far as GBP sentiment is concerned with the global financial market focus on fiscal sustainability.  In addition to this we get the Bank of England’s Monetary Policy Committee meeting minutes for April and whilst the inflation concern has been muted since the latest CPI release, any movement towards the ‘hawkish’ camp may well reignite the debate – and GBP’s fortunes.

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With a run of consecutive ‘short’ working weeks in the UK and the Easter school and market holidays, there is a noticeable drop in activity and liquidity in financial markets which is exacerbated by a quiet spell in the global data calendar.

This week however has got off to a lively start as the eurozone debt debacle takes another turn as a result of yesterday’s Finnish elections.  The Finnish vote sparked fears of a political ‘euro-skeptic’ uprising across the 16 nation zone as the True Finns (the leader of which has suggested that taxpayers should not have helped Greece or Ireland) became Finland’s biggest party for the first time, with 20.4% of the vote, and are now almost certain to have a significant inclusion in the leadership coalition.  (the Social Democrats – who won 19.1% of the vote and also opposed bailouts for Greece and Ireland, were also above the current Prime Ministers party with just 15.8% of the vote.).  The new government is due to be appointed on the 19th of May after coalition talks. 

This additional uncertainty added to the eurozone sovereign debt crisis has been viewed as an unwelcome development in financial markets and the yields of the peripheral bonds have widened again this morning as investors shun exposure to their government bonds in favour of the relative safe haven of Germany (or indeed UK or US).  Portuguese 10 year yields have this morning reached a new EMU high of 9.04% and Greek 5 year CDS is now pricing a 64.5% chance of a default within 5 years. 

The initial reaction to the weekends developments (and the risk aversion in periphery bonds this morning) has been to sell the EUR and there has been some evidence of further position unwinding through the 1.4350 technical level.  However, we have mooted the situation in the eurozone on this page before and our view remains that the ‘troubles’ will be contained to the PIGs but will not spread to the PIIGS (or more clearly Italy and Spain will not require the bailout facilities offered to Portugal, Ireland and Greece).

In the eurozone the PMI surveys tomorrow will be keenly watched for signs of continued momentum in the core manufacturing and service sectors.  Any signs of slowing momentum here may lead to a further correction in the EUR but we still see this as corrective and that the EUR is in the process of building momentum, for a break of 1.4530 and beyond over the rest of Q2.

In other developments over the weekend, China raised the reserve requirements for its banks (a form of monetary tightening) by a further 50bps as expected and World Bank president Robert Zoellick said that the global economy is just one shock away from a full crisis.  We expect the risk aversion and position unwinding to wane as the week progresses and for the USD to once again be questioned on currency markets but for the moment the peripheral eurozone debt markets remain the dominant driver.

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The last couple of trading sessions in financial markets have been dominated by position unwinding in the face of ‘risk off’ sentiment. Equities have struggled to make any new gains and have fallen back from recent highs while bonds have been more mixed, with the inflation vs safe haven trade-off making directional bias less clear.

What has been apparent over the last few sessions, however, has been the resumption of spread widening in the eurozone periphery vs core markets, with Portuguese and Greek bond yields pushing to new record highs and their respective spreads to Germany making new ‘wides’. All eyes are on Spain as the ‘battle ground’ for the containment of sovereign debt contagion and, despite moderate pressure over the last 48 hours, this is a battle that will likely be won – effectively ring-fencing the PIG (Portugal, Ireland and Greece) from the rest of the eurozone ‘animal farm’.

In the world of foreign exchange, this has added to volatility but, in my mind, it has not changed the core underlying dynamic – USD weakness and a continuing move towards economic (and interest rate term structure) differentiation.

Inflation concerns have been brought back to the forefront of financial markets overnight with the release of Chinese producer and consumer price inflation, where the latter bounced back in March to levels suggestive of further monetary tightening to come. India also released consumer price data this morning at a lofty 8.98% year on year. This focus has continued into G7 today as eurozone CPI data for March rose to 2.7%, solidly above the ECB target level and again suggestive of further monetary tightening ahead. The US equivalent this afternoon is more difficult to call but is expected to rise to similar levels to that of the eurozone.

This is where the similarity ends, however, as a dual-mandated fed, with no formal inflation target and biased towards the much better behaved core inflation (in conjunction employment growth), will be considerably less motivated to tighten the monetary stance as a result of a higher headline inflation print – particularly while Bernanke, Yellen and Dudley (who’s views could be viewed as “more equal than others” at the Fed) remain firmly in the dovish camp.

That moves us neatly on to the UK and comments overnight from outgoing MPC member Andrew Sentance. Sentance maintains his hawkish view on current monetary policy, suggesting that inflation may exceed 5% this year as it is compounded by GBP weakness. In clearly stating that he “does not see the case for keeping low rates”, his view on the economy (potentially bar the housing market) is that the recovery is continuing and that inflation remains the main threat.

His main point, and one that we wholeheartedly back, is the notion that the weakness of GBP “as a conduit of monetary policy” may have been underestimated by the MPC. He went on to say that “My concern is that the pound has weakened beyond what is really necessary for the rebalancing of the economy and it’s actually contributing to inflation and making macroeconomic management of the economy more difficult … If a rise in interest rates began to counter some of that weakness of the pound, I wouldn’t see that as an unwelcome development.”

Interest rate expectations in the UK have come back very significantly since the weaker CPI print for March. However, inflation is likely to increase strongly again next month and beyond, interest rate expectations will again build and a renewed date for the start of the rate hiking cycle will be mooted (which we think is likely earlier than the current market expectation of August), Alongside these, GBP is significantly undervalued.

Strong opportunities exist amidst the current volatility

Have a great weekend.

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Overnight, foreign exchange reserve accumulation from China along with Singapore’s impressive 23.5% Q1 GDP gain once again highlight the extent of global trade and growth imbalances. The USD50 billion rise in China’s FX reserves for March may also account for some of the downside pressure on USD over the month and is likely to continue as the USD index hits a new low since December 2009 this morning.

The emerging market dynamic is a very important driving force behind G10 FX and, indeed, Fixed Income. As the growth differentials between G10 and Emerging Market (or perhaps, more correctly, developed and developing) economies have grown from the depths of the crisis, pressure for Central Banks to intervene in currency markets to stem the appreciation of their currencies vs the primary market base currency (USD), has grown. This accumulation of USD, in addition to the trade accumulation, has meant that the USD’s which have been accumulated at an increasing rate need to be diversified, in line with national foreign exchange reserve policies.

Glenn Stevens, Governor of the Reserve Bank of Australia, sees the “economic centre of gravity moving to Asia” and that the “world needs to attune our ear to Asia’s rhythms”. His comments underline the sentiment that the emerging or developing world is having a greater impact on the global economy and, indeed, on the major economies’ financial markets. The subject of recycling USD will be a topic that we will discuss in further detail over coming weeks, but it is a core dynamic that is a key component in shaping USD’s medium-term prospects.

In the very short term, the disappointing global equity backdrop is keeping a broad ‘risk off’ sentiment prevalent across financial markets and, as such, is confusing a number of core themes. Market participants that have been late to position themselves for recent moves are finding the pullbacks difficult to bear, and this is adding to short-term volatility as nervousness grows.

From a data perspective, US producer price inflation will be the core focus of the day as a signal of pipeline inflationary pressures. A bigger dynamic is at play for USD but, for today, nervous markets, position unwinding and the USD inflation debate may provide better levels to get involved.

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Over the last couple of trading sessions, GBP has been on the back foot. The initial trigger for this was the fall in consumer price inflation in March (the first drop in the headline annual rate since July last year) causing the front end of the UK interest rate curve to push back the first hike, which is now largely expected in August (the next quarterly inflation report month). In addition, the OBR release of February construction growth estimates led many economists to revise down their estimates for Q1 GDP. This combination of downward revisions to both growth and inflation has put GBP under pressure, particularly vs CHF and EUR.

However, as we have previously mooted here, while GBP has slipped down the ladder of currencies we would like to own, it remains above the ‘rates on hold’ currencies of USD and JPY where the fundamental backdrop has also been deteriorating.

From this point, however, there is no significant data from the UK until the middle of next week when we get the April MPC minutes and the final set of public finance data for the fiscal year 2010. There is a good chance that the deficit comes in below the forecast level and this, combined with the 'dataless' period where the focus may return to USD woes, could give GBP an unexpected (by the broader market) reprieve.

In the eurozone, interest rate expectations continue to grind higher and, while the high frequency economic data has been a bit more mixed of late, the economy is on the clearest road to recovery of the major economies at this juncture and the currency is reflecting this.

Inflation data from the US this week at both producer and consumer levels will be keenly watched for further impetus to the USD downside as rate divergence between the eurozone (in particular) and the US grows. 1.4530/50 is the next important zone for EURUSD and a break of this is likely to draw further capitulation of short positions and, more broadly, lower FX forecasts.

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The main theme over the past 24 hours has been one of a general profit taking mood across equities, high yielding currencies and commodities – all of which have performed spectacularly well of late.  This ‘risk off’ sentiment gathered pace overnight as the Japanes authorities raised the nuclear crisis severity level at the Fukushima Nuclear facility to 7 – the highest possible alert level.

Softer economic data from the UK, together with the lower than expected inflation data has prompted short term accounts to sell GBP against a variety of currencies.

The BRC retail sales survey showed a disappointing headline figure, where like-for-like sales fell 3.5% month on month – the biggest decline on record for the series. However, the decline is exaggerated by the inclusion of Easter in the 2010 data, which is not included in the 2011 numbers. CPI data this morning has had a similar impact, with the headline rate falling from 4.4% in February to 4.0% in March. While this has lead to a number of official forecasts for the timing of the first UK rate hike to be pushed back, the headline rate is still double the Bank of England’s target level of 2%, and there are few signs that the headline rate won’t continue to push higher in April. The MPC may breathe a temporary sigh of relief, but their debate is far from over. Indeed, any weakness in GBP, will simply compound inflationary pressures.

On the positive side, the RICS house price survey showed an improvement in the housing sector for the fifth consecutive month. More importantly, February’s trade data showed a marked improvement as exports of goods to the non-EU sector increased significantly – underlying both the competitiveness of the UK at current exchange rates and the rising trend in demand from developing nations.

We foresee a short period of consolidation in financial markets as equities have failed to make any fresh headway over the past few sessions. Alongside this, the deterioration of the situation at the Fukushima nuclear facility has inspired some safe haven flows.

The underlying backdrop for USD, however, remains one of ‘lower for longer’ interest rates and the rhetoric from deputy Fed chair Janet Yellen has confirmed the dovish bias of the more senior members of the committee. From a technical perspective the USD remains entrenched in a broad based downtrend (click here for USD index chart) and we expect that any rallies will continue to be sold into.

EUR continues to benefit from a clearer outline of the rate normalisation process and is now approaching levels (vs. USD) where it is likely that funds and corporate interest, that has so far remained on the sidelines, will get drawn into EUR buying.

With regard to GBP the underlying picture has not changed significantly and the UK’s position on the grid of those countries about to embark on the interest rate normalisation track has not altered. From a technical perspective GBP remains on the back foot against a broad range of currencies but its performance against both USD and JPY continues to impress and confound its critics, of which there are many (click here for chart of GBPUSD) (click here for chart of GBPJPY).

Over coming months we expect to see further gains in the stronger growth / higher yielding economies / currencies with the USD and JPY vying for the weakest spot and by default the funding currency of choice.

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The market focus on inflation is likely to continue this week, with important consumer price data from the eurozone, the UK and the US.

In the UK, the inflation rate is expected to have steadied at around 4.4% in March following last week’s factory gate inflation, which showed manufacturers passing on input price increases at a faster pace. For GBP over the last couple of days, however, the focus has been more mixed: the ONS release of construction output forecasts for February has caused many to pare back their expectations for Q1 GDP (despite the fact that construction only accounts for 6.3% of national output). This has, in turn, caused many to suggest a delay in the start of the rate normalisation process. Combined with concerns that the Vickers report would impose draconian restrictions on UK banks, this has led GBP to underperform into last week’s close. The fact that the report was, perhaps, not as imposing as had been feared alongside the renewed focus on the high level of consumer prices, may well see rate hike expectations renewed and GBP strength return as this week progresses.

In the US, the hawkish commentary from some (voting and non-voting) members of the Federal Reserve board at the start of last week has been replaced by a considerably more dovish contingent at the start of this week. Deputy governor Janet Yellen openly stated that the “economy does not yet warrant exit from stimulus”, and this places her clearly in the camp of Chairman Bernanke (and Dudley), likely to keep USD on the back foot through the week.

In the eurozone, the upward pressure on the interest rate curve continues as 10-year German yields hit 3.5% for the first time since August ’09 and the eventual (if not overdue) capitulation of Portugal to accept a bailout seems to have halted the run of contagion. The Spanish bond market, seen as the battleground for the containment of the sovereign debt crisis, continues to trade well.

Today is very light on data and we are likely to see little significant movement. However, as the week progresses, the themes of last week are likely to re-emerge as we look for probes of USD downside, EUR upside and a reinvigoration of UK rate expectations.

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As ECB president Jean-Claude Trichet delivered on his promise from the previous months statement yesterday and raised the benchmark interest rate for the 16-member eurozone, the G7 chronicle (excluding Canada, which has already embarked on its cycle of monetary tightening) moves into a new chapter, quite simply entitled ‘policy normalisation’.

Trichet was explicit in his view that the adjustment of current policy was warranted on the basis that liquidity remains ample (a core facet of the ‘separation principle’ intended to guide the periphery nations’ financing requirements through the adjustment process), but upside risks to inflation have been clearly identified and the anchoring of inflation expectations is important for growth and, indeed, a prerequisite for policy.

Trichet disappointed some rate hawks by not entertaining the press conference questions probing him for his expectations for the course (or pace) of future rate hikes. He stuck clearly to the mandate, in suggesting that the governing council has not decided whether this is the first in a series of rate hikes. However, he was explicit in his assessment that risks to the inflation outlook remain, driven largely by domestic price pressures and he gave ‘dictionary corner’ what they were looking for in the statement that they will continue to “monitor developments very closely” which, in ECB speak, suggests another 25bp hike in June ceteris paribus.

In the UK this morning, we have seen further evidence of input price pressures in the manufacturing sector and, indeed, cost increases being passed on to the consumer at an increasing rate. The argument that current price pressures are a result of energy price shocks and, as a result, are transient, just will not hold any more and the UK will be quick to follow in the footsteps of the ECB, with the May meeting now the expected start of the UK normalisation process.

I have frequently discussed my views on USD on this page and other written commentary over the past weeks. This move is just getting under way and, with the US failing to reach a conclusion on the budget debate, government closure and low rates continuing for an “extended period”, a gradual slide in USD looks set to continue.

Have a great weekend.

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Today is a very important day for financial markets. The ECB is almost certain to deliver the first rate hike of the cycle, taking rates off the historic low of 1.00%. Last week’s “strong vigilance” language was taken by the market as a clear indication that a 25bp hike at today’s meeting was a ‘done deal’. In fact, last month President Trichet went even further than that in suggesting that, in his view, rates are likely (though not predisposed) to move higher at the April meeting.

Upon delivery of the expected interest rate rise at 12:45, the market’s attention will immediately shift back into ‘forensic lexicography’ mode, as the inference and sentence construction of the accompanying ECB statement at 13:30 are critically assessed. The interest rate market is currently expecting 133bps of tightening over the next 12 months, or almost a 25bp hike at every other meeting.

With the divergence in the eurozone growing, austerity measures due to tighten consumer and business expenditure and with continued dependence of periphery banks on ECB funding, many commentators will be suggesting that a rate hike at this stage is a negative for the zone and potentially for EUR. However, Trichet made it clear at last month’s meeting that the primary mandate of the ECB is to provide price stability to the 300 million eurozone members, and will act on the area as a whole. The problem of peripheral debt concerns and ‘addicted banks’ will be dealt with through the EFSF(ESM)/IMF bailout funding (as was requested by Portugal officially last night) and through emergency funding measures under M Trichet’s ‘seperation principle’ of monetary accommodation within an overall tightening bias.

In the UK, the BoE is, in all likelihood, still a month away from the start of the rate hike cycle, as the ‘wait and see’ camp on the MPC will want to see the May Quarterly Inflation Report forecasts before entering a path of monetary tightening.

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The minutes of the US Monetary Policy Board’s March meeting last night provided further evidence that the Fed will complete QE2 in full. Despite rhetoric from policymakers and commentators alike over recent weeks that the US growth story is sufficient to terminate the second quantitative stimulus early, seem to have been, at best, the musings of a minority on the FOMC and, at worst, significantly jumping the gun. Indeed, recent data suggest that the positive developments in growth and inflation that we saw in the first couple of months of the year have cooled.

This is a very significant development in financial markets and more importantly in terms of its implications for USD. Despite the recent hawkish rhetoric from Fed governors (some voting FOMC members and some not), the fact remains that US interest rates remain on hold and, as long as real US interest rates remain negative, the direction of USD is likely down!

There are some plausible caveats to this on the foreign exchange markets, notably JPY and CHF, where improving risk sentiment and global growth prospects will begin to favour USD (some signs of this have been seen over recent days).

With the FX markets still intimately focussed on interest rate differentials and the relative pace with which global central banks will now start and ultimately achieve the process of interest rate normalisation, macro economic data becomes more and more important in its role to confirm or contradict interest rate rise expectations.

In that regard, two pieces of data have shaped the trading day. Firstly, Swiss consumer inflation for March proved much stronger than expected, which drove rate hike expectations and CHF higher. Secondly, in the UK, manufacturing production for February had the opposite impact as a sharp drop in the volatile oil and gas extraction component confounded expectations and countered the very strong services sector survey data (that drove GBP higher) yesterday.

In the bigger picture, despite the surprise jump in Swiss prices, they are still at very modest levels (particularly if you subscribe to the popular central view that current commodity price pressures are transitory). More importantly, the manufacturing sector in the UK accounts for about 13% of output, whereas the services sector accounts for over 70%. Today’s data may have extended the discussions on the legitimacy of a May rate hike in the UK, which, for me, is still the most likely outcome. CHF may have its day in the sun today but tomorrow is likely to tell a different story.

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After the excitement and anticipation of the US employment report at the end of last week, this week has got off to a fairly sober start with trading confined to a narrow Monday range.

Today, however, there has been a slight resurgence in activity, as UK service sector PMI has ignited the GBP bulls and frustrated a swathe of UK corporate interest hoping for lower levels to buy the pound.

Service sector PMI rose to its highest level in a year, from 52.6 in February to 57.1 in March. The service sector is by far the dominant sector of UK economic activity and, as such, the PMI is consistent with growth of around 0.8 – 1.0%. The breakdown showed new orders, current orders and employment all rising, with business expectations slipping slightly from high levels, most likely due to concerns over imminent fiscal austerity measures.

If we couple the strong UK data with slightly disappointing European data this morning, then GBP should begin to climb the ladder of favoured currencies over the next few weeks. The suggestion from the deputy Editor of the Economist that the UK economy is better placed than Europe and the US (I have published my views on USD on the ECU website – click here) further support this view.

US service sector data will be keenly watched this afternoon along with the ECB interest rate decision. The ECB is overwhelmingly expected to deliver on its promised – but never pre-committed – rate rise, and this, combined with the US service sector data, will be the dominant drivers for FX and interest rate expectations.

The market’s focus for Thursday is likely to be more on the press conference and on how hawkish Trichet remains, should he deliver on the expected interest rate hike, rather than on the rate hike itself. However, the implications for GBP could also be bullish as today’s data has put the May rate hike firmly back on the table.

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